Puerto Rico Financial Troubles Deepen

Bloomberg news reported this week that the President of the Commonwealth of Puerto Rico Senate was headed to Washington to meet with US legislators. The purpose of his visit is to lobby for an amendment to Chapter 9 of the Federal Bankruptcy Code, to allow the struggling Island to be covered under the same bankruptcy statute now available to US cities, counties and local districts.  A similar measure adopted by the Commonwealth in June 2014, the Puerto Rico Corporations Debt Enforcement and Recovery Act, was struck down by US courts as unconstitutional this past February. US Treasury Secretary Jack Lew has already informed the Island that a Federal bailout is not in the cards. 

With the news of Puerto Rico's approach to Washington breaking, it should be quite evident what the Island's plan is for resolving the debt crisis. The Commonwealth, along with the Teachers' and Judicial Retirement Systems are struggling with $37 billion of unfunded pension liabilities, high debt loads, a sluggish economy, falling tax revenue and a declining population.

For holders of the roughly $72 billion of bonds issued by the Commonwealth, this is a bit more salt in the wound. The struggling protectorate issued $3.5 billion in tax-exempt bonds in March 2014 to help stabilize its finances, constituting the largest municipal junk bond offering in history. The bonds, largely sold to hedge funds and offered at an initial price of 93 now trade around 80, resulting in a loss of 13% to those who purchased at the initial offering price just last year. Paulson & Co is reported to be one of the largest purchasers of the 2014 deal, along with DoubleLine. Commonwealth bonds are also owned by Fir Tree Partners. With the recent decline in prices, yields on Puerto Rico triple tax-exempt bonds are now higher than taxable bonds of Greece and Argentina.  

Revenue of the Island this year is projected to come in at $250 million below prior estimates, with a looming budget gap of nearly $200 million to be resolved by the end of the Commonwealth's fiscal year, this June 30. As a solution to the budget issues, legislators have proposed a $500 million reduction in spending and a hike in the Island's sales tax from its current rate of 7% to 11.5%. In addition, a bond payment of $630 million is due the first day of the new fiscal year, or July 1.  

The Puerto Rico Electric Power Authority (or PREPA) faces budget and financing challenges of its own. The Island's main energy provider is negotiating with creditors to whittle down its $9 billion of debt and avoid a default on a $416 million bond payment, also due July 1. With no legal remedies available to it and all sides lawyered up, this looks to be heading for a messy and involved litigation.

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.

Rising Yields on Treasury Bonds

We've seen a startling and unexpected move to higher yields on the UST 10-year over the past two weeks, with yields rising from 1.87% on April 17 to 2.24% on May 6. Market professionals are scratching their heads to understand the backup in rates amidst weak Q1 GDP, durable goods, factory orders and most recently, ADP private payrolls. 

Much of the latest tantrum followed a prescient call by Bill Gross on shorting German BUNDs, for which those investors following his advice would have profited considerably. Soon to follow were prognostications by a variety of equity guys, including Warren Buffet, who while a demonstrated equity maven, might not be the best source of advice on bonds. Warren's a bit like your family doctor, who skilled in medicine seeks to give advice on a range of subjects beyond his expertise.

For his part, Warren is an old school cronie, not unlike John D. Rockefeller or J. P. Morgan, who built fortunes on the intersect of politics and business. But a bond trader, not so much. Equity guys fail to understand how bonds trade or the simple fact that bonds, unlike stocks, have terminal value.  

For those who make their living in the sector, bonds trade on price, not yield. The price reflects the ownership of a stream of future cash flows. As robust economic activity and the prospect of inflation discount the value of those cash flows, bonds diminish in value. Conversely, weak economic growth creates value. In the deflationary world that Bernanke so feared, bonds would scream.

All of which is to say, the weak level of recently reported economic fundamentals argues that the current tantrum may not have legs and, at least in this one instance, an investor might profit by taking the other side of Warren's trade.

Early Social Security Benefits and the Labor Participation Rate

Marketwatch reported today on the percentage of Social Security recipients taking "early" benefits from Social Security. A surprisingly high 73% of recipients or nearly three out of four, now elect to take benefits prior to full retirement age, thereby significantly reducing the benefits that they will receive in retirement.  

Full retirement age for those born between the years 1943-1954 is defined as age 66, with the date gradually increasing.  For those born 1960 or later, 67 becomes the new full retirement age. Social security benefits are available to those retiring earlier than these ages, but at a reduction of 13% for those electing benefits at 65, the age most commonly associated with retirement (reduced benefits are actually available as early as age 62, but at a 30% reduction). For those waiting until age 70 to take social security, benefits increase each year by 8% relative to the full retirement age, up until age 70 when they are capped. The benefit claimed at any of these ages, is then fixed for the duration of the person's retirement.

These changes were put in place as part of the Social Security Amendments of 1983 (HR 1900) when the Trustees of the Social Security Trust Fund first became concerned about the solvency of the Trust relative to future benefit payments. Interestingly, this act also expanded Social Security benefits to members of Congress and the White House and instituted the taxing of benefit payments to recipients. What Congress giveth with one hand, they taketh away with the other.

Most retirement planners advise people to wait as long as possible to claim benefits. But the point of this article is not to advise people on their selection, but rather to examine the social and economic issues that drive behavior. There are several reasons why people might take early, reduced benefits including illness, or because they believe they can invest the funds at a higher rate of return. The most common reason, though, is that they simply need the money. But there is another reason to consider: Social Security benefits are not guaranteed. The Trustees of the Fund can change the level of benefits going forward at any time.

Of these reasons, the fact that people need the money is both the most likely explanation and the most telling of the limp recovery following the financial crisis.  Along with the significant rise in disability claims over the past six years (and the vast expansion of the student loan program) early social security benefits likely explains the last piece of the puzzle in the pronounced and lengthy decline in the labor participation rate.

Rising Rents

There was an interesting article on Business Insider today about the rising cost of rental housing in America. If you rent your home or apartment, or know someone who does, you're well aware of what has happened to rents over the past five years. The article mentions one important factor driving demand, the shift from homeownership to renting following the financial crisis, with 36% of people currently renting versus 31% before the crisis.

This is a very compelling consideration, and raises some important questions about housing policy, the banking sector and the Federal Reserve. What's driving the increased demand for rental housing are several factors, including limited supply and cumbersome local zoning/approval requirements for new development. But also driving rents are the tightened mortgage approval standards of banks for home ownership, following the collapse of the shadow banking market. The shadow banking market (or the market for private label mortgage backed securities) fueled the growth of sub-prime loans, no-doc loans and other inventions of the early 2000s by providing a secondary market for banks to sell these newly originated loans. With this market still largely defunct and in an environment today of weak personal income growth and rising bank lending standards, those seeking new housing are increasingly forced into the rental market.

Now landlords, amidst this growing demand for rental housing are for the large part killing it. They've been able to finance new multi-family or refinance existing developments at historically low interest rates, while enjoying ever escalating rents from tenants. Nice work if you can get it. But this pronounced shift to rental housing once again highlights Fed policy, post recession and it's wealth effect on the average citizen.

Large corporations have been able to reduce borrowing costs dramatically since 2008, now borrowing 10-year debt at interest rates as low as 3.00%.  But small businesses have struggled to access financing for new projects. Owners of homes have been able to refinance their mortgages at generally lower rates, although bank standards have biased approvals to the wealthiest with the best credit in an environment of greater regulation. And let's not forget the wealth effect the Fed has created for the owners of stocks. But bear in mind, as with home refinancing and corporate financing, stocks are very narrowly held (with 80% of stock ownership held by the top 10% of Americans by wealth) thereby shifting this benefits of Fed policy to the wealthiest.

All this raises the very obvious question about who has benefited and who has not from the Fed's six-year policy of zero interest rates and whether it might be time to redress these imbalances that the Fed has created.

Fidelity: 401(k) and IRA Balances Hit Record Highs

Earlier today, CNBC posted a report with the above title on their website.  The article referenced a new report of Fidelity Investments that claimed that 401(k) and IRA balances hit record highs in the first quarter of 2015, with the average balance now standing at $91,800.  Now, the article doesn't exactly identify what constitutes the "average", whether this is intended to be the median balance of accounts at Fidelity or just the simple arithmetic mean.  Either way, it doesn't quite square with other research, including data of the Federal Reserve.

Tracking just how much individuals have saved in IRA and 401k accounts is tricky business, due to the various measures used to report the data.  Many sources, including brokerage firms and mutual fund companies report their data as a simple arithmetic mean: they add up the total balances in all IRA and 401k accounts they manage and divide by the number of people holding those accounts.  Thus, the estimated $102 million that Mitt Romney is believed to hold in his IRA is averaged in with the $15,000 of the average middle class household.  It’s just not a meaningful number.

No slight to Mr. Romney’s contribution to America’s retirement savings, but for the data to be reported in a way that is of any value in understanding the current retirement crisis, the “average” balance needs to be calculated on the basis of the median.  To do this, of course, you simply line up all the account balances at a place like Fidelity from smallest to largest, and find the account in the precise middle by value, with exactly fifty percent of accounts holding greater balances and fifty percent holding lesser.  This would only tell you, of course, what the average balance is of investors who hold accounts at Fidelity (and, therefore, not representative of the average American) but it’s certainly more realistic than reporting an arithmetic mean.

While the median value of retirement assets has risen in recent years, according to recent data of the Federal Reserve Bank the portion of respondents who even owned a retirement account of any sort fell to less than half, continuing a downward trend that began in 2007.  For those who are fortunate enough to have a 401k account, even with recent record gains in stock prices, the median balance of 401k/IRA accounts was just $59,000 at the end of 2013.  At a four percent recommended annual spending rate in retirement, an account of this size would produce (pre-tax) retirement income of less than $200 per month, or less than the average American family spends on groceries each week. 

UST Negative Yields

Sounds crazy, doesn't it? The idea that the US Treasury, or any government could be paid to borrow money is contrary to everything we've learned about finance and the time value of money. Yet, strange as it sounds, there are now 17 countries whose sovereign debt trade at negative yields, including Austria, Belgium, Denmark, Finland, France...well, you get the idea. Even 2-year sovereign debt of the Czech republic traded in negative yields this week.

As of this writing, the German 2-year bond is yielding -0.27%, while the 5-year was at - 0.11%. This means that an investor will accept -0.27% less of his principal investment back each year for the next two years, for the privilege of keeping money parked with the German government . When Swiss yields dropped below zero, everyone rolled their eyes, but reconciled the silliness with the idea that this was Switzerland where wealthy foreign investors, for reasons of safety, have stashed large sums of cash  for generations. Swiss government bond yields are now negative out to ten years.

But yesterday's crossing of Japanese bond yields into negative space, has us really scratching our heads. After all, there as many highly informed, highly educated investors who believe that Japan's fiscal woes are unsolvable, as not. If repayment is in question, then how are investors being compensated for risk?

The question is, what's happened to credit spreads; the idea that each borrower's debt yield "spreads" to some "risk free" rate of interest, based upon credit-worthiness? With US credit ratings previously in question, the risk free rate has more recently shifted to Germany. And with the ECB now buying bonds of european central governments, many of these nations' debts are showing negative yields.

Bill Gross, the legendary bond king came out last week and argued that the German 10-year, currently at 0.16% is the short of a lifetime. Meaning, those investors betting that German yields will rise (and therefore the price will decline) stand to be handsomely rewarded. Far be it for us to disagree with any bond royalty, but in this case maybe not so fast.

What's far more interesting is the credit spread of the 10- UST to German bond, with UST now yielding 1.80% over the Bund (http://www.investing.com/rates-bonds/government-bond-spreads). By the way, if you're looking for something more juicy, take a look at the Brazillian 10-year, now yielding 12.60%. Wasn't it just a few years ago that all the talk was about the BRICs? Now, the Russian 10-year is at 11.20%, India at 7.66% and what did the "C" stand for again?

Getting back to the point. While German 10-year yields may be unsustainable at this level, shorting the Bund is a dangerous proposition. Remember John Maynard Keynes adage, "markets can stay irrational longer than you can stay solvent". The more interesting trade is the US 10-year, now yielding a 25-year high relative to the Bund (ideally, you'd want to short the Bund and go long UST to play this trade, but a simple long position might be worth considering). 

It's also interesting to consider what could cause this credit spread to widen. Negative economic news in the US? While theoretically, bad economic news should widen a spread to the risk free rate, such news would also cause interest rates more generally to decline (due to lower inflation risk) thereby improving the long trade. And good news? This might cause rates to rise, but in a compressed fashion by a tighter spread to the Bund. Thus, the ECB is effectively anchoring the yield of most developed world debt. This all suggests that the most likely scenario is that credit spreads narrow over time, lowering UST yields and boosting prices. Safer to be long the UST 10-year, than short the Bund.

As to the Fed and raising rates, we think the Fed is in a box for quite some time, the subject of a future post.

California Pension Crisis 5.0

We found this news story from a couple of weeks back quite startling.  Organized and supported by public employee labor unions, protestors picked up signs and marched out front the Sterling Hotel in Sacramento, while chanting anti-Wall Street themes.  This activity was all part of an effort to express their opposition to a forum being held inside the hotel by the Reason Foundation to explore possible solutions to the public employee pension crisis in California http://www.sacbee.com/news/politics-government/the-state-worker/article18192998.html. Now, we support first amendment rights in all instances, including this one, but the themes of the protest are quite curious.  

It has us thinking about a much broader issue that has crept its way into American politics and business, as well, for that matter.  I like to refer to it as "a thumb on the scale".  The ideom refers to the practice of unethical butchers in days (hopefully) long gone, of slipping a thumb onto a scale used to weigh a customer's purchase to inflate the price.  Scales for weighing meat and other products are now more commonly in plain view, and we'd like to believe used by a new breed for whom such open customer display is not even necessary.

But the practice has more general application to those in the worlds of business and politics who, in an all consuming desire to succeed, might be willing to cheat ever so slightly to out-maneuver an unsuspecting customer, opponent or audience.  We're not implying anything outrageous, illegal or even overtly unethical, after all, influencing outcomes is in part what political campaigns and marketing efforts are designed to do.

The practice of "spinning" news for political gain crept into the common vernacular in the 1990s. The idea was to reinterpret the news for the viewer to bias the viewer's perception.  Before long newscasters on the nightly news were referring to political aids as "spin doctors" (not to be confused with the highly talented musical act of the same name).  In short span, America had managed to legitimize an activity of highly suspect intent.

So what does all of this have to do with a union organized protest in Sacramento?  Perhaps this photo is a good place to start.  These protestors are voicing their opposition to efforts under discussion in California that could, in their estimation, limit pension benefits to which they are entitled by virtue of their employment by public agencies.

But it's the sign being held up that caught our attention.  The sign reads "Good for Wall Street...Bad for the Rest of Us" and in so doing characterizes efforts to limit public employee benefits as being initiated by or inuring to the betterment of Wall Street.  On the face of it, you might be wondering what in the heck Wall Street has to do with any efforts to limit public employee pension benefits. And in this instance at least, closer inspection will not cause the argument to make any more sense.

The argument, awkwardly put forward by the labor unions - and to which this poor soul holding up the sign may actually be convinced - is that Californians are somehow faced with a choice.  Either favor the interests of hard working school teachers, police officers and firefighters, or do something that would benefit those evil, greedy demons on Wall Street.  But now the reasonable person might ask, how are these two unlikely groups even remotely connected?

If I'm following their argument correctly, and I admit it's a bit of twisted logic, I'm guessing it has to do with the bankruptcy case of the City of Stockton.  You see the city, faced with insurmountable debts to the CalPERS pension system, bondholders and other creditors, was forced to file for bankruptcy in 2012.  Despite the Judge in the case opining that the obligations to all creditors, including CalPERS could be amended by the bankruptcy process, the city, in its reorganization plan chose not to do so.  That is, the city chose to fulfill its obligations to its pension system in full, but renege on its promises to repay bondholders who had lent the city money for a variety of public purposes.  Now call me old fashioned if you like, but my Dad taught me that if someone lends you money, you have an obligation to repay it.  In full.

One of the purposes for which the city borrowed money, was for building a new fire station.  One of the investors in those bonds was Franklin Advisors, who purchased $35 million of the city's bonds back in 2009, long before any talk of bankruptcy.  It deposited those bonds into two of its municipal bond funds.  Per the bankruptcy plan, now approved by the courts, however, Franklin will be paid 12 cents on the dollar that it invested, leaving its fund with a $30 million loss on its investment.

Now, I guess this is where Wall Street must come in.  Apparently, Franklin and other investors who lent the city money for vital public projects must be considered by the unions "Wall Street" firms, even though Franklin is located in San Mateo, California and runs mutual funds that invest in municipal bonds, and whose shareholders are retirees and other ordinary citizens.  But, then again, public sentiment is decidedly against Wall Street.  

Now here's where the thumb gets slipped on the scale.  The union organizers or public sector employees who printed this sign must clearly know that.  To not, would be ignorant.  Let's assume, as is likely the case, that it's the former.  So, knowing quite well that private individuals like you and me might be investors in these Franklin funds, and would suffer losses from Stockton's failure to repay its promised obligations, why in the world would the unions represent otherwise?  Could it be that if the interests of public pensioners were pitted against those of ordinary citizens, it might be more of a fair and reasonable fight?  And who wants that anymore.  I mean, when it's just so tempting to tip the scales.