Prophet of Doom: Will the Public Pension Crisis Wreak Havoc in the Tax Exempt Securities Market?

Eight years ago Wall Street’s Meredith Whitney predicted “50 to 100 sizeable defaults” in the municipal bond market within the next year.  Ms. Whitney is noted for her correct call in 2007 that Citibank would incur massive loan losses in the 2008 financial crisis on toxic mortgage loans.  Ms. Whitney’s calls on muni debt were wrong —- or as some people now believe —- too early!

A recent Wall Street Journal article (https://www.wsj.com/articles/prophet-of-muni-market-doom-wasnt-wrongjust-early-1540554098?mod=searchresults&page=1&pos=1) points out that today there is $8 trillion of municipal debt outstanding, half owed to bondholders and half owed to pensioners.

The half owed to pensioners is especially troubling since $1.4 trillion (34%) is unfunded.(https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2018/04/the-state-pension-funding-gap-2016) Pew Charitable Trust (PEW) points out that this “deficit represents a $295 billion jump from 2015 (to 2016) and the 15th annual increase in pension debt since 2000”. States and municipalities have failed to adequately fund their pension plans to meet the employee benefits they have promised.

Compounding this Pension GAP problem is that most public pension funds use rosy assumptions as to future investment yield in the calculation of their liabilities to their pensioners. PEW reports that the median investment assumption is a 7.5% annual yield. With 2 to 3% US Treasury yields today, 4% corporate bonds, and 5.5% junk bond yields, stocks and alternative investments are the only way to reach a 7.5% annual compound yield on a portfolio today.

PEW reports “In 2016, half of plan assets were invested in equities, a quarter in alternative investments, and another quarter in bonds and cash”. (https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2018/09/state-public-pension-funds–investment-practices-and–performance-2016-data-update) Equities and alternative investments are inherently more risky than investment grade corporate bonds. Equity and alternative investments (real estate, private equity and hedge funds) have risen from 5% of pension fund assets in 1956 to 74% of assets in 2016.

PEW reports: “Ten-year total investment returns for the 44 funds in our study that report performance net of fees as of June 30, 2016, ranged from 3.8 percent to 6.8 percent, with an average yield of 5.5 percent. Given that the average target return for these plans was 7.5 percent, the long-term variability is significant. Notably, none of these plans met or exceeded investment return targets over the 10-year period ending in 2016.”

Such large deviations from the 7.5% annual compound investment assumption can have major consequences for any portfolio.  Pew applied a 6.5% return assumption, instead of the median assumption of 7.5%, to estimate the total liability for state pension plans and found that it would increase to $4.4 trillion—$382 billion more than the current amount. The funding gap would then jump to $1.7trillion.

The State of Illinois is a prime example of the difficulties beginning to show up in the tax exempt bond market. (https://money.cnn.com/2017/06/29/investing/illinois-budget-crisis-downgrade/index.html)  Reportedly Illinois has $15 billon of unpaid bills and a $250 billion pension liability ($162 billion unfunded).  Illinois is at risk of losing its investment grade credit rating with a downgrade to “junk” status. In July, after two years, Illinois finally passed a state budget with a $5 billion tax increase.  (https://slate.com/news-and-politics/2017/07/after-two-years-illinois-finally-passed-a-budget.html) Nevertheless, Illinois is still not out of the woods. The huge unfunded pension liability will hang over the state for years requiring future tax increases to meet funding needs as baby boomers retire.

What does this all mean for the market for tax exempt securities? 

 Any large defaults or credit downgrades will affect all tax exempt borrowers resulting in higher borrowing rates and more restrictive loan terms. In a severe credit crisis the tax exempt bond market may freeze up for an extended period of time as it did in the 2008 financial crisis.

 This is especially problematic for the tax exempt market because the typical bond buyer is an individual retail buyer or a tax exempt fund buying on behalf of individual retail buyers.  Individual buyers and buyers’ funds rely on credit ratings, restrictive loan terms, and collateralized escrow deposits as security for the bond. If more near defaults, credit downgrades and actual defaults occur such as Detroit, Stockton, and San Bernardino, faith in the credit rating agencies will degrade.

This happened before in the 2008 financial crisis when AAA rated mortgage bond pools went into default with little warning.  Faith in the credit rating agencies was severely degraded when it came to underwriting real estate mortgage bond risk.

How can Midwest Credit Lease help?

MCL sells private mortgage bonds exclusively to professional investors at life insurance companies and other institutional investors.  These investors rely upon the balance sheet of the borrower and the borrower’s mission and operation.  Unlike retail buyers, they do not rely exclusively on the borrower’s credit rating. They perform their own credit analysis. 

 Private bonds sold to life insurance companies can fully amortize within the term of the loan. Maturities can be as long as 30 years with fixed rates for the term of the loan.

 Our investors are in the market when retail buyers and funds are not.CTL terms are reasonable with no restrictive covenants or costly collateralized escrows.  Upfront costs are lower than public bond issues and loan maturities longer than loans available from banks.

 For your next development call Midwest Credit Lease for a quote.

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