A little more than a year ago, following Detroit’s bankruptcy, I drew attention to the Commonwealth of Puerto Rico’s impending default (“Puerto Rico: Have I Got a Deal for You”).
The precipitating event that drew my interest was a $3.5 billion dollar bond issue at the time that was enthusiastically over-subscribed by yield-hungry investors. The back story was similar to Detroit’s bankruptcy: a long-term economic decline (aggravated by a reduction in US military outlays on the island), politicians unwilling to implement serious reforms to stimulate private sector employment, and papering over financial problems with ever-larger borrowing programs.
Too much debt. In late June, Governor Alejandro Padilla announced that the Commonwealth’s well had truly run dry: $79 billion in debt issued by the Commonwealth and government-sponsored companies, most importantly the island’s electric utility, “is not payable.”
Much of this debt is held by U.S. mutual fund investors, who were attracted by the federal, state, and local tax exemption accorded to Puerto Rico’s interest payments on its bonds. The Federal Reserve’s low interest rate and “quantitative easing” policies surely reinforced the temptation to stock up on Commonwealth paper.
A sizable portion of the debt is insured by specialized financial companies, such as MBIA and Assured Guaranty. The later has already stepped up to provide the power company with $128 million to make a July debt service payment.
While the bond insurers will suffer serious losses and some mutual funds will take sizable hits, no major “systemic” financial disruption is likely to follow Puerto Rico’s default.
A wake-up call? However, a much-needed re-evaluation, on a nationwide basis, of debt-drugged state and municipal government finances could – and should - get underway. That re-evaluation should start with state and local government pension systems.
Much of the spadework has already been done. The Centre for Retirement Research at BostonCollege has recently updated its comprehensive survey of state and municipal pension plans. These are the single greatest source of future critical problems for state and local governments – and their taxpayers and employees.
A fifth of all plans have a funding ratio (assets relative to liabilities) of less than 60%, and even that number is pie-in-the-sky since it assumes the plans will earn 7.6%, on average. If public plans used the return assumption mandated for private plans (currently around 4%), the funding ratio would fall to 45%, implying a financing shortfall of $3.9 trillion.
But with rare exceptions (Rhode Island being one), state and local governments refuse to confront the problem. Illinois and New Jersey don’t even make the required payments to hold their funding ratios at current levels. In some cases, they simply “double down” as they say in a poker game when a player is on a losing streak: issue “pension bonds” and throw the proceeds back into the financial markets, hoping to earn that 7.6%.
Simple arithmetic mandates that some combination of less generous pensions and higher contributions by both employees and employers/taxpayers will eventually emerge. Getting there in some cases will look like Detroit’s long travail (Philadelphia appears to be following that path). Illinois may turn into another Puerto Rico or Greece.
But the real tragedy is that such costly financial dramas are avoidable – if the political class accountable for state and local government has the foresight and energy to confront reality, and avoid the siren lure of ever-larger debt loads and financial obligations.