One way to put a quick sheen on pension funds’ balance sheets is to issue municipal bonds at a lower rate of interest than the pension fund is expected to earn. These “pension obligation bonds” (POBs) have a long and checkered history. The first one was sold tax-exempt by the city of Oakland, Calif., in 1985. It stirred up a hornet’s nest at the IRS, which quickly realized that the lower tax-exempt interest rate was subsidized by Uncle Sam in a no-brainer for the pension fund that in theory could just invest in taxable bonds to make a profit, even without risking money in stocks. Congress was prodded to prohibit the use of tax-exempt debt where there is a profit-seeking investment “nexus,” and thus was born a thick book of IRS “arbitrage” regulations. Consequently, POBs must now be taxable, with a higher interest cost.
When interest rates are low, as they are today, the underwriters and many financial consultants come out of the woodwork to pitch their POB deals. The lure is always the same: “Over 30 years, you will save money because history shows it’s almost a certainty that stocks will outperform low bond yields,” even if they are now taxable. I’ve written extensively on the foreseeable cyclical risks of selling POBs when the stock market is trading at record high levels: The underwriters and deal-peddlers will sneak away with their fees from the deal, and public officials will be left holding the bag whenever an economic recession or stock-market plunge drives the value of their pension funds’ “new” assets below the level of their outstanding POBs. The Government Finance Officers Association (GFOA) has long opposed POBs for this reason, among others. POBs make sense to me only when they are issued in recessionary bear markets.
Behind Mr. Greensill’s failure: The business went beyond the scope of what it initially set out to do. Many of Greensill’s loans went to a small circle of borrowers close to Mr. Greensill, as well as acquaintances and his biggest outside backers.
A Wall Street Journal review of internal Greensill records, including board minutes and emails, along with interviews with more than a dozen people familiar with Greensill’s business, reveals how the company obscured its riskier loans behind a safe but barely profitable supply-chain finance business.
Greensill took on bigger, riskier long-term loans. In some cases, the loans were given other names before they were sold on to investors in the Credit Suisse funds, obscuring who the borrower was or the type of loan, the Journal found.
It is a miracle anyone ever listens to us. Honestly, sometimes they shouldn’t. Other than the theory of comparative advantage, I can’t think of any correct economic insights that defy common sense. Economists, or experts in any field, are meant to offer a framework to weigh costs and benefits, help us see risks, and understand how the economy and people respond to shocks and policy. This helps people make choices that are right for them. If someone is pushing something totally counterintuitive, whether in economics or public health, we should be skeptical.
The same goes for debt. I heard someone say MMT has become an accepted theory – that is simply not true. And there is nothing new here. If you look at the history of debt cycles and financial crisis, they often featured some convoluted justification for why taking on tons of leverage isn’t so risky after all because this time was different – we are so much more clever now. Guess what, you might use some big words that tell you otherwise, but debt is always risky. Sure, some of the time it works out and juices higher growth, but when it doesn’t, things get really nasty.
Gordon thinks very highly of Ben Meng and so do I. I’ve had the pleasure of talking with him a few times since he was appointed CIO at CalPERS and not only is he brilliant, he was always very nice and generous with his time.
The last time I spoke with Ben was in the summer via a webcast where he explained that CalPERS is not leveraging its portfolio by $80 billion. We spoke about a few things and I recommend you read my comment here to gain an appreciation of everything he was tying to do at CalPERS.
The main challenge facing the public pension industry is the high assumed rates of returns on pension assets relative to what equities or bonds are likely to deliver.Many US public pension funds expect a rate of return in the neighborhood of 7% per year. But in today’s capital-market environment, achieving that sustainably over the long term has become an increasingly daunting task.
In fact, this is not a new problem. As Chart 1 illustrates, the gap between the risk-free and assumed rate of return has been widening for the past four decades. In the1980s, the risk-free rate (as approximated by the yield for ten-year US Treasury bonds) was often far higher than the assumed rate of return, making it relatively easy for pension funds to hit their targets. Today, however, the risk-free rate is more than six percentage points below targeted return.