San Bernardino Circles the Drain

Just released were details of San Bernardino's bankruptcy recovery plan. Referred to more delicately as a "plan of adjustment", the proposal calls for repaying bondholders one-percent of their investment in city bonds, or a penny for every dollar loaned the city. Perhaps encouraged by the City of Stockton, who in its bankruptcy reorganization plan repaid investors 11 cents per dollar, it's nonetheless a punishing outcome for those who invested their savings in municipal bond funds that hold San Bernardino bonds.  

Further reported in the city's plan, are significant reductions to its firefighting forces, in a region well-known for wildfires. The bankruptcy plan also calls for cuts to ambulance services, park maintenance and graffiti removal, while extending a temporary sales tax, approved by voters back in 2006. As if these cuts to services weren't troubling enough, given the drubbing bondholders will take on their investment in San Bernardino bonds, it's hard to see how the city will raise money in the future for needed public projects. Fool me once...

A study of salaries of the 120 highest paid firefighters in San Bernardino reported by Bloomberg shows the top one-third drawing an average salary of $190,000 per year; the next third $166,000. In retirement, as early as age 50, these firefighters may be eligible for annual pensions of up to $171,000 per year, an obligation the city will need to pay for many years to come. This might, in part, explain the types of management decisions that led up to the city's bankruptcy. 

Nevertheless, it has us wondering just what becomes of cities like San Bernardino, Stockton and Detroit. Higher taxes, reduced services and limited public improvements are hardly the building blocks of future growth and economic prosperity. Yet 200,000 residents continue to call San Bernardino their home, raise their families there and seek to enjoy its public amenities. The city has let these residents down, much in the way it now proposes to let down investors who loaned it money to build out its infrastructure. Let's just hope, and against significant odds, that the city's plan of recovery actually works.

Chicago Junk Bonds

Hard to believe it's come to this, but municipal bonds issued by the Second City are now considered junk bonds. Moody's lowered the rating on Chicago's bonds this week to "Ba1", below investment grade. The rating change was prompted by the rating agency's continuing concern with the city's public employee pension liabilities. The unfunded portion of the city's ten public pension funds now totals a daunting $37 billion. Standard & Poor's and Fitch continue to rate the city in the "A" category, however, showing a considerable divergence in views with Moody's on the depth of the city's woes.

The rating change for the city comes on the heels of a recent ruling of the Illinois State Supreme Court, which just last week struck down a pension reform measure championed by Governor Pat Quinn and passed by the Illinois State Legislature in 2013. That ruling, potentially disastrous for the state facing its own massive unfunded pension debt, also has negative implications for Chicago.

The rating change affects over $8 billion of bonds outstanding, with investors holding those bonds seeing their price degrade day by day. General obligation bonds issued by the City of Chicago in 2012 and due in 2033 yielded just 3.75%, or a spread of roughly 100 basis points to high quality municipal bonds. By 2014, however, with concerns already beginning to emerge about the city's pension problems, bonds of the city of equivalent maturity were sold at a yield of 4.87%. The yield represented a spread of 170 basis points to the high quality index.

As of today, those same bonds issued just last year at 4.87% are now trading at a yield of 5.51% or at a spread of 2.81% to the index.  With price moving inversely to yield, this represents a loss of $5.45 per $100 of value (or 5.45%) to investors who purchased the bonds at the offering just last year. If the bond ratings are similarly dropped by S&P and Fitch, the bonds will unquestionably fall much further in value.

Far higher interest rates on new borrowings of the City and the losses suffered by investors in the city's outstanding bonds may be the least of it, however, with interest rate swaps entered into by the city from years earlier posing a vexing problem for the troubled city. The downgrades may permit banks that had entered into interest rates swaps and other derivative products with the city to now demand payment on upwards of $2.2 billion of those agreements. Similar downgrade provisions helped force Jefferson County, Alabama into bankruptcy a few years earlier.

The past few years have seen some of the largest, and most frequent bankruptcy filings of local government in US history. Jefferson County, Alabama, the cities of Vallejo, Stockton, San Bernardino, Central Falls, Harrisburg and Detroit have all filed, largely due to excessive debts and pension liabilities. The Commonwealth of Puerto Rico, with a staggering $73 billion of US municipal debt outstanding now teeters. Chicago, now in junk status, is on deck.

April Employment Report

The April employment report of the Labor Department showed a 223,000 change in non-farm payrolls with the unemployment rate dropping to 5.4%, in line with forecasts. Less noticed perhaps in the report were the significant downward revisions to the March employment report, with jobs being revised down by 40,000 to 85,000 for the month. The bond market has taken the news hard, as if April employment exceeded forecasts and March was revised higher, rather than lower. Go figure.

The fascination, though, with the employment report in both equity and debt markets is slightly puzzling. The theory, of course, is that job creation creates income and spending power to drive consumption and GDP. It would also signal improved confidence of businesses, seeking greater employment. But there's a disconnect between theory and practice, with Q1 GDP significantly below the economy's tepid 2% annual pace and forecasts for Q2, equally as grim.

Nevertheless, it's the unemployment rate, that soundbite of 5.4% that seems to catch the attention of bond traders around the globe. This fascination sustains, despite great controversy surrounding the number itself, and the impact of a stubbornly low labor participation rate upon the calculation. If we are trying to measure the propensity of consumers to, well, consume, perhaps the unemployment rate is not the best measure.

In addition to the unemployment rate, the Bureau of Labor Statistics also publishes a ratio of employment to population. This, to our thinking, might be a better representation of the portion of the population that is both generating income and consuming, versus the portion of the population, like children and the elderly, that primarily consume. The latter two groups, in effect, access financial resources to support their spending from parents, savings and governmental spending, rather than through income generation.

This ratio has been stuck, stubbornly, at 59%, give or take a couple of basis points, since 2009. After falling considerably from its levels in the years preceding the financial crisis, the ratio has failed to recover during the economic recovery that began in 2009. There can be many explanations for this, including the advancing of the Baby Boomers into retirement, a process that itself has been linked to the sluggish recovery, rather than the other way around. It can also be linked to the explosion of student loan borrowing, elevating college and post-college attendance. And lastly, it can be attributed to the soaring rates of disability claims, following the Great Recession.

Whatever the explanation, America needs to find a way to employ a greater share of its population and raise the median wage of that employment if the intent is to once again rely upon the consumer to fuel economic growth. The latter will be a subject of a future post.