San Bernardino's Pension Fiasco

New details emerged this week on the City of San Bernardino's bankruptcy recovery plan. Reuters reported a proposed settlement with two of the creditors of the city's 2005 pension obligation bonds. That plan calls for bondholders to write off as much as 60%, or $30 million of their original $50 million investment. 

The bonds in question were originally issued by the City back in 2005 to help shore up the city's struggling public employee pension fund, held by the California Public Employee Retirement System, or CalPERS.  Unable to come up with the funds to fulfill its commitment to retirees, the city turned to the public bond markets, selling bonds and using the proceeds to pay CalPERS. In being granted authorization under law to issue the pension bonds in 2005, the city obtained a court ruling confirming that the city wasn't issuing new debt, per se, but rather refinancing debt it owed to the CalPERS pension fund.

By July 2012, though, soon after it filed for bankruptcy, the city failed to make required semi-annual payments on the bonds, throwing the bonds into default.  Interestingly, in its bankruptcy filing, the city blamed the high costs of its fire and police labor contracts, including pensions as the main issue forcing the bankruptcy filing. Now in bankruptcy, the city failed to make payments on the bonds funding that pension liability, as well.

The two principal holders/guarantors of the bonds sued the city soon thereafter, arguing that the bonds should be paid on an equal basis with the city's continuing obligations to fund its pension account at CalPERS.  But in the end, the powerful, $300 billion CalPERS prevailed in court. In May 2015, a bankruptcy judge threw out the bondholder suit, allowing the city to proceed with its plan to make pension payments to retirees in full, while forcing bondholders to suffer significant losses on their loan to the city.

Now let's step back here a moment and take a look at what has actually transpired.  The city, through negotiation with its employee unions, had agreed to make a certain level of lifetime pension payments to retired city employees. Unable to come up with the funds from tax revenues and other sources to do so, the city borrowed $50 million from investors. It deposited these funds with CalPERS, the pension trustee, on the city's behalf.  

Now, in cramming down a loss of $30 million (or 60%) to bondholders, the city is arguing that it doesn't have the funds to make full repayment. However, it actually does. The full $50 million that the city borrowed, plus interest, remains on deposit in the city's pension account with CalPERS. So, in effect, what has happened is that the city effectively stole $30 million from investors (the difference between the original borrowing and the amount to be repaid) using the money to make whole on its pension commitment to employees.

Now, here is where this gets truly galling. As reported in our blog from May 2015, 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 (this is in a city where the median household income is $52,112 per year). 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 and its nearly unconscionable deal with its bondholders.

Much more on the public pension and retirement crisis can be found in my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon.com. 

The Dash For Trash in Stocks

Following an unusually rough start to 2016, the last four weeks have seen a dramatic turn of events in stocks, oil and commodity prices. The question we ask is "what has changed?" Unfortunately, not very much. Our concerns entering 2016 are still with us: record low commodity prices, weak oil, widening junk bond yields, declining corporate profits and a less accommodative Fed.  These concerns are superimposed upon a bleak macroeconomic picture, with many starlets of the emerging markets stumbling, including China, and others falling hard, like Brazil.

Amidst this backdrop the rally in stocks has been puzzling. Driving these gains, in part, was a race to hastily cover short positions in oil, as a rumored OPEC alumnae reunion quickly sent the price of oil up by 50%.  Oil analysts, though, shrug off the effect of a plan to freeze production at today's record levels (even assuming parties would hold to it) as having little impact on ever-growing inventories.  However, as weak shorts run to cover in oil and beaten down oil stocks, hedge funds and algorithmic traders have been quick to ride the tailcoats of all the buying.

But let's look at one non-oil, non-mining blue chip stock to see what has happened to valuations over the past several weeks. Boeing Corp (BA) bounded off its mid-February lows of 108, to now trade at a robust 130.  Little has actually changed at the company over this period. In fact, the company announced in late February that it would be laying off employees, including highly paid engineers, as it faces stiff competitive market pressures, principally from Airbus. This news followed a downbeat earnings report for 2015 Q2, released on January 27, in which the company lowered forward earnings guidance on an expectation of slower 2016 sales. Boeing's net in 2015 Q4, it turns out, was $1.03 billion, down from $1.47 billion in the same quarter a year earlier. 

Yet despite this 29% drop in Q4 earnings and lowered guidance for 2016, Boeing stock is up a stunning 20% from its February 11 low.  So how is this possible?  Multiple expansion. Today, BA trades at 17.15x twelve month trailing earnings, above its 5-year historical range of 16.19x. But with earnings projected to decline, even if not nearly to the degree the company experienced in 2015 Q4, this TTM multiple will jump significantly, without any further gain in the price of its stock.

Now this isn't to say that Boeing is a weak or troubled company. It is an outstanding company, with excellent long term prospects. But these prospects must be set against global macroeconomic conditions that support, or in this case, limit growth. This issue, in fact, is precisely what the company warned in its Q4 earnings statement.

Meanwhile far trashier stocks, like Chesapeake Energy (CHK) are up 201% over the past four weeks, while Freeport McMoran (FXC) is up 187%.  It's much more difficult to value these stocks on a TTM p/e basis, because these stocks do not have earnings.  Not by a long shot. FXC lost $12.2 billion in fiscal 2015. If you think this might give pause to the reasonableness of a 187% rise in FXC's stock price, you might want to consider treading cautiously in this newfound market rally.

The Rising Mountain of New Jersey Pension Debt

This week, the Supreme Court of the United States moved to uphold a 2015 ruling of the New Jersey Supreme Court, thereby defeating a challenge to the state's plan of pension funding brought by public employee labor unions. The unions sued the state over the underfunding of the state's staggering employee pension deficit. The unions alleged that in 2014 Governor Christie failed to fund the plan at an agreed upon level, per a deal negotiated by state legislators and the unions in 2011.

To understand where this story begins, or just how dire the circumstances are surrounding the New Jersey Public Employees Pension Fund, a bit of background is required. In 2014, the State of New Jersey deposited roughly $700 million of taxpayer dollars into its employee pension fund. The State spent an additional $2.8 billion of public monies to fund retiree health care benefits. Yet, despite these significant investments in shoring up the retirement plan of its past and current employees, the State actually underfunded its statutory funding obligations by nearly $3 billion.

To understand how this is possible, we need to delve into the murky world of state and local government accounting. To fully fund the state's requirements, simply to keep pace with current pension costs - with no effort to catch up on past underfunding - would have required the State of New Jersey to contribute $6.5 billion of taxpayer funds, or 20% of the entire state budget to its pension funds. So the state "saved" $3 billion by underfunding in 2014. But year after year of these kinds of "savings" or deferrals, simply builds one heck of a mountain of debt, or pension liabilities, for the state (or more specifically, taxpayers) to climb in the future. In fact, by 2015, New Jersey's total benefits liabilities had reached a staggering $90 billion - $37 billion in unfunded pension liabilities and $53 billion in unfunded health benefits.

Now back to the Supreme Court. The case revolved around the agreement negotiated in 2011. In order to gain concessions from the unions on greater employee pension contributions, the state agreed to gradually increase its funding of pension contributions in each year, until reaching the required annual level. And in fact, things proceeded just this way in 2012 and 2013.  But in 2014, in an effort to pass a strained budget, the state reduced its annual pension contribution by the aforementioned $3 billion. Governor Christie claimed financial hardship. The unions sued saying the stated had breached its 2011 deal. The Supreme Court has now sided with the state, allowing the State of New Jersey further leeway in kicking the can down the road on its pension obligations.

Looking ahead, for the state's fiscal year 2017 beginning on July 1, the Governor has proposed $1.86 billion in pension contribution, or just 40% of its required annual contribution. And while this may help the state balance its 2017 budget, the state's pension mountain continues to rise before New Jersey public employees and cast an ever-greater shadow over its taxpayers.

Much more on the public pension and retirement crisis can be found in my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon.com.