The city of Tucson, Arizona decided last year to pay the rent for five golf courses and a zoo to itself. In California, West Covina agreed to pay the rent on its own streets. In Flagstaff, Arizona, a new lease includes libraries, fire stations, and even the town hall.
These are risky financial agreements, born out of desperation, made to meet rising pension payments that cities can no longer afford. Starved by the pandemic, cities are essentially using their own property as a kind of security to raise money to pay their workers’ pensions.
Here’s how it works: the city sets up a front company to hold assets and then rent them out. The company then issues bonds and sends the proceeds back to the city, which sends the money to their pension fund to cover the shortfall. These bonds attract investors desperate for yield in a world with near zero interest rates by offering a yield that is slightly higher than that of similar financial assets. The pension fund, in turn, invests the money raised by these bonds in other assets that are expected to generate higher returns over time.
If they can execute the strategy, cities that issue these bonds can cut their pension bills by an amount that is the difference between what they earn and what they pay off. But as with any strategy based on long-term assumptions, there is risk.
Taxpayers can still owe the pension fund money if the investments do not produce the expected return. And while most municipal debt is bulletproof because a government pledges to bail out its creditors if it defaults, bonds like the one issued by West Covina have no guarantees.
“It puzzles me that anyone would buy these bonds,” said Jessica Shewmaker, a member of West Covina City Council, when an investment banker came up with the idea of a $ 1.2 million monthly bill from California last year Cover Public Employees’ Retirement System or CalPERS. “These are roads that haven’t been paved in 20 years.”
Across the country, cities and towns are increasingly pursuing more aggressive investment strategies as they struggle to fill funding gaps in their retirement programs. According to Pension Tracker, a project under the Public Policy Program at Stanford University, the total nationwide shortage of public pensions is around $ 4.7 trillion.
Many states have tried to improve their pension systems, which often means asking local governments to send in much more money. Few cities only have cash these days, but they can long-term borrowing from investors with terms so far in the future that it feels like free cash. For example, West Covina bonds do not have to be paid back for 24 years.
When a community borrows money for a public project such as a new road or bridge, it typically issues a general bond, often after getting voter approval. This is the backbone of local government finances and offers solid guarantees – courts can force borrowers to pay, even if it means a tax hike.
However, it is different when a municipality takes out loans to cover a pension shortage. Usually this is done with a pension obligation. These also require voter approval in some states, but typically offer fewer guarantees to their buyers.
It gets darker when municipalities adopt the West Covina approach. Because the bond is issued by the dummy company, it is often referred to as something else – in the case of West Covina, a “lease revenue bond” – and does not necessarily need voter approval.
The consequences of this approach became apparent after Detroit filed for bankruptcy in 2013 and failed to pay its creditors in full.
Like West Covina, Detroit had used bogus companies to borrow money after it was directed to fund its retirement. Several years later, in bankruptcy, Detroit attempted to reject the $ 1.4 billion bond, calling it a bogus transaction in which bogus companies circumvented a legal debt limit. When the dust settled, bondholders got about 14 cents on the dollar. The city’s retirees also cut their hair.
The website of the 20,000-strong Government Finance Officers Association, whose stated mission is to “achieve excellence in public finance,” yells pretty loud, “State and local governments shouldn’t issue POBs.”
That didn’t deter the governments. Nationwide, cities and states spent $ 6.1 billion in pension obligations in 2020 than any other year since 2008. This comes from data compiled by Municipal Market Analytics, a research company. States with significant new retirement loans last year included Arizona, Florida, Illinois, Michigan, and Texas. In California, cities borrowed more than $ 3.7 billion to bid farewell to various public pension funds, breaking the old state record of $ 3.5 billion set in 1994.
It’s making a big comeback for this type of debt, said Matt Fabian, a municipal Market Analytics partner who has been writing the deals for years. “They borrow money and basically put it in the market and play,” he said.
Mr Fabian said his company’s balance sheet almost certainly missed borrowing from local governments that were taking West Covina’s approach as those bonds used different names. Flagstaff rented its town hall, libraries, and fire stations last year to support a retirement contract marketed as a “certificate of attendance.” In January, Tucson did the same, renting two police helicopters, a zoo conservation center, five golf courses, and grandstands on the rodeo grounds, among other things. And a Chicago suburb, Berwyn, used “submitted tax securitization” to fund police pensions.
The street rent that West Covina, a former citrus farmer outpost about 20 miles east of Los Angeles that is now submerged in urban sprawl, pays the front company is essentially the money to service the debt. By issuing this debt, the city was able to make a lump sum payment of approximately $ 200 million to CalPERS.
Like many urban retirement plans that CalPERS manages, West Covina is only partially funded. CalPERS is treating the shortfall of roughly $ 200 million as a loan to West Covina that will charge 7 percent interest. That’s an exceptional rate in today’s environment, but CalPERS uses it because that’s the average return the pension system generates on its investments.
By repaying most of its “loan” from CalPERS, West Covina doesn’t have to worry about the 7 percent interest rate, at least for now. The Risk: If CalPERS misses its investment objective, West Covina will again underfund the plan, CalPERS will treat the shortfall as a new loan and the whole process will start over.
When West Covina considered its deal, the city’s investment banker, Brian Whitworth of Hilltop Securities, estimated the city would pay 4 percent for the borrowing. With CalPERS generating a 7 percent return, the city would save an estimated $ 45 million.
“It’s a pretty good saving on a $ 200 million bond,” he said.
No one asked for a prediction of what could happen if CalPERS didn’t reach 7 percent. Instead, Mayor Tony Wu grilled Mr Whitworth about why he believed West Covina had to pay 4 percent when El Monte next door only paid 3.8 percent.
The proposal was passed 4 to 1 and Ms. Shewmaker voted against because she viewed the plan as a gimmick to avoid bringing the matter to voters who she believed would likely not approve a deal that would West Covina debt would increase sixfold.
Mr. Wu, now a councilor, said the city had to borrow because it was tied to unsustainable pension plans and CalPERS refused to negotiate simpler terms. The longtime mortgage business owner said it was “crazy” for CalPERS to base everything on 7 percent when real rates were much lower. But he said challenging CalPERS would be a waste of time.
“It sounds very logical, but it’s not going to happen because those in power don’t want to lose it,” he said. “They will fight us a lot. They’re going to sue us to hell. Your lawyers will laugh at the bank. “
