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March 26th, 2012

The Day The Music Died

The Day the Music Died once denoted Don McLean’s lyric ballad, but now connects the Philadelphia Orchestra to the same smoke and mirrors pension financing that is rife throughout the U.S. The Philadelphia Orchestra filed for bankruptcy this past April and has thrust its pension problems upon the thinning shoulders of the Pension Benefit Guaranty Corporation. The Philadelphia problem is a familiar one: defined benefits juxtaposed against a highly volatile, uncertain asset pool (donors) and weak investment performance by the pension fund. Simultaneously, the aging retiree pool is growing allegro while the pool of contributors is growing adagio. This is the same math problem seen at law firms who fund retirees out of current earnings and large municipal funds who “fund” by using fictionally high actuarial assumptions coupled with the fantastic assumption the municipal budget is infinitely elastic.

The scope of financial yoga has recently expanded in an attempt to avoid what is, at its essence, a math problem. NYS municipal governments grabbed the prize for Best Impersonation of a Fiduciary by introducing a novel asana: Rather than making their required annual pension contribution, since they did not have the cash, they borrowed $1 billion, in 2011, from their own pension funds and “contributed” it back to the pension funds. Were this to be proposed by a private citizen to its investors, cynics might label it a scheme that rhymes with Hansi.

Municipalities queuing at the bankruptcy gates now include Harrisburg, Pa; Central Falls, RI; Prichard, AL; Vallejo and Stockton, CA. The California cases are most remarkable for the heavy-handed way in which CALPERS has tried to intervene in the town’s bankruptcies. Normally, in bankruptcy, all claims are on the table in order to hammer out a solution that causes all parties to share in the pain of the solution. CALPERS, which manages pension funds for many of the towns, has declared state law does not permit any diminution of present or “future” pension benefits for existing public workers. They have told town officials they will sue the towns and make the towns pay CALPERS’ legal bills if the towns attempt to reduce pension benefits in bankruptcy. This threat of state law trumping federal is waiting to be tested in either the Stockton or other California municipal bankruptcies. That CALPERS, which has earned a 1% ROI over the last decade, but continues to use a 7.75% actuarial assumption, is granted a continuing voice in fiscal matters is comic. Per usual, CALPERS’ executives continue to moralize publicly about governance or fair income tax rates, yet have no introspective ability as they put their states’ employees financial future into a skid designed to end in a crash.

Alarming numbers, pointing to the high percentage of U.S. households that have no or negative equity in their home, suggest nearly a quarter of the population is in this struggling category. Setting aside shenanigans by banks to extend loans to the non-creditworthy, and federal law or policies that encouraged risky behavior, there are a few other comments to be made about this group. They took financial risk that presumed a continued rise in housing prices and/or continued employment were certainties when they borrowed the money to buy their homes as integral to their repayment plan. Sadly neither of their assumptions held true and these borrowers had no plan to deal with the “rainy day” problem. Many state governments are now in an analogous position. They are wildly overleveraged as their assumptions of continued tax revenue and pension asset growth have not occurred. As the beacon for the masses that government purports itself to be, what plans do states like New York and Massachusetts offer as their lynchpin of fiscal sanity for their populations of over-leveraged homeowners? Casino Gambling! These two states, among others, are now proposing multiple additional casinos be built to remove even more cash from their over-leveraged constituents’ pockets. Neither state has changed any existing employee benefits nor made the hard choices made by the Philadelphia Orchestra. Since Connecticut already has casinos that earn more than 50% of their revenue from NY and MA customers, this scheme is likely to shuffle the proverbial Titanic deck chairs for a few years until the next municipal budget crisis occurs.

Contrasting with the U.S. municipal model is the Mondragon Group of producer cooperatives located in Basque Country in Spain. Founded in 1956, they now include 250 subsidiaries employing 100,000 members who are guaranteed employment, relocation or 80% of salary payments during slack demand times. Mondragon is now Spain’s seventh largest industrial group. The Mondragon also feature profit pooling and the reverse. As the recession arrived, losses in one unit were covered by profits in others. Without a strike workers cut their own wages, vacation time and even had four week pay docked at Christmas in 2008.

The essential lesson of Mondragon for the U.S. pension crisis is: a large population can arrive at common sense solutions if all variables are identified and all constituents participate in the process. Rhode Island, which served as the poster child for irresponsible municipal management has now emerged as the leader in making the hard choices as they recently addressed both income taxes and benefits for existing public employees in a special session of state lawmakers. This effort was led by Gino Raimondo who was aided by the state’s sudden realization that the original mission to drain the swamp, had been superseded by the news the swamp was full of alligators, as retiree costs equaled 50% of tax collections in some Rhode Island cities.

On the bright side is Joshua Gotbaum. When American Airlines announced plans to file bankruptcy and a coincident plan to hand the airline’s underfunded pension funds to the Pension Benefit Guaranty Corporation, that Gotbaum directs, he placed liens on $91 million of assets outside the bankruptcy to force the airline and the unions to compromise to avoid the PBGC inheriting an $8 billion liability. The result was a freeze of three of the four airline pension plans and no government assumption. Gotbaum should receive a medal from the President. Congress should give thought to either granting equity to the PBGC in the plan sponsor of any company that emerges from bankruptcy that has placed its pension plan with the PGBC or granting the PGBC a priority claim in bankruptcy equal to the unfunded liability.

Since we have now begun the official Frankendodd era, it would be irresponsible to fail to mention the many ways Congress has now protected institutional investors. Olympus now has a fifteen page policy for voting proxies. (In twenty two years we have never voted a proxy). We are now paying a custodian thousands of dollars to hold valueless unregistered stock certificates. We are required to monitor our employees purchases of municipal bonds. We are required to pay for audits of entities in which none of our investors have an investment. The list is a long one and applies to all private fund managers with over $150 million in assets. Yet as I write this, Congress and the White House have just passed JOBS bill that exempts “emerging companies” from many of the SEC rules and regulations including an independent audit of internal financial controls. “Emerging Companies” are defined as those with up to $ 1 Billion of revenue! The same font of wisdom that determined institutional investors armed with large law firms need protection if assets exceed $150 million has now also decreed that the average public shareholder does not need such protection unless revenues pass $1 billion! Next on the legislative agenda: How to sell a bridge in Brooklyn.

I’m Rob Morris and I approved this blog.

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