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It’s probably worse than we think

Wednesday, Mar 4, 2009 - Posted by Rich Miller

* Bloomberg has a very scary story about pension bond schemes, including an ill-advised Chicago Transit Authority deal that has crashed. This is a very long story, so make sure you read it all. Here are some excerpts…

With stock market losses this year, public pensions in the U.S. are now underfunded by more than $1 trillion.

That lack of funds explains why dozens of retirement plans in the U.S. have issued more than $50 billion in pension obligation bonds during the past 25 years — more than half of them since 1997 — public records show. […]

The CTA concluded it could borrow $1.9 billion, paying an interest rate of 6 percent to bondholders, and invest the proceeds to receive its expected rate of return of 8.75 percent. Such an annual return would add $52 million a year to bolster the fund.

The CTA chose to ignore not only Illinois’s auditor general but also its own actuarial firm, Detroit-based Gabriel Roeder Smith & Co. The company had determined there was just a 30 percent chance of earning 8.75 percent.

“We executed the best transaction we could, given the legislative and political restraints,” says CTA Chairman Brown, who is also co-head of municipal finance at Chicago-based Mesirow Financial Inc.

Since the bond sale, the authority has held the money as cash, earning 2 percent. And, with the credit crunch forcing municipal bond interest rates up to attract buyers, the CTA wasn’t able to sell bonds with a 6 percent return.

A team of underwriters, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley, sold the CTA bonds in August 2008, at a yield of 6.8 percent, so the fund had to pay bondholders more than it had expected.

“There is negative arbitrage,” Brown says. “It’s better than having dumped the money into the equity market.”

I’m afraid to even call the state pension funds to see how Blagojevich’s scheme is holding up.

Again, go read the whole thing. But let’s try not to get into some goofy debate about the stock market and the president and whatever, OK? This isn’t just about the current stock market conditions. The CTA was warned not to do this and they did it anyway. Let’s try to keep the talk as focused as possible.

* Meanwhile, the Tribune is one of the first newspaper editorial boards to actually propose or at least suggest some large-ish budget cutting ideas, even if they were cribbed from the Civic Committee of the Commercial Club of Chicago…

Reforming how Illinois does business may well require unpopular steps: moving Medicaid recipients into managed-care programs; outsourcing food, janitorial, technology and other internal services; slimming revenue sharing and grants to local governments.

But Illinois desperately needs to create the government it can afford to replace the government it has now. A new report from the Civic Committee of the Commercial Club of Chicago puts the state’s unfunded present and future obligations at $116 billion—almost $10,000 for every man, woman and child. The report says that total could be increasing by as much as $10 billion a year.

We hope Illinois lawmakers, from Gov. Pat Quinn on down, caught this comment from committee Chairman W. James Farrell: “We need someone to take action, and that action has to be reform [and] cut costs—what responsible people do when they can’t live within their means. You really can’t tax your way out of this problem. If you tax your way out of this, businesses would be leaving the state in droves.”

Think that’s an idle threat? Illinois has trailed the nation and the rest of the Midwest in job creation for years. Piling on taxes will put more people out of work.

* Oh, come on already

Illinois still has not officially submitted a list of shovel-ready road and mass transit projects to the federal government for funding under the economic stimulus package, U.S. Transportation Secretary Ray LaHood said Tuesday, warning that time is running out.

“The law requires us to get the money out the door very quickly,” LaHood said. But “we have not received a list from the state or from Chicago.”

State transportation officials vowed to get moving with the application process, but they expressed no concerns about possibly losing federal aid. […]

The deadlines vary depending on the different modes of transportation. But the stimulus legislation aimed at putting Americans to work requires Washington to distribute funding to the states for highway, bridge and transit projects by March 10, which is 21 days from the law’s enactment.

Illinois would not be eligible to receive any money until the General Assembly approves a special appropriation totaling $693 million to cover contracts for the first round of stimulus projects in the spring, according to the Illinois Department of Transportation. Once the money is spent, the federal government would reimburse the state.

* Now, on to some frivolity because I’m too depressed from reading all this gloom and doom. This could be pretty cool

One thing is for sure, security will be tight if the Fenwick boys basketball team makes it to the Class 4A Farragut Regional Championship to face Whitney Young on Friday night (March 6, 7:30 p.m.). After all, the governor may be on hand, as well as His Airness.

But before the Friars can have the pleasure of playing in front of Gov. Pat Quinn, the brother of Fenwick head coach John Quinn, and Michael Jordan, the father of Marcus Jordan, who plays for Young, they’ll need to find a way to get past Farragut on its home court tonight (Wednesday, March 4, 8 p.m.). Even though the Admirals are having a bit of a down year - they’re 15-9 and seeded eighth in the Morton Sectional - a first-round win won’t be automatic for the Friars, who closed out the regular season last week with a 61-33 slashing of Northside Prep. Fenwick is 16-9 overall and was awarded the 10th-seed in the sectional.

“We’ve had an up and down season, but we’ve managed to stay on the positive end of things,” said Fenwick head coach John Quinn. “Our tendency to have a bad quarter in a game just can’t happen against the teams we could possibly face early in the playoffs.”


  1. - Leroy - Wednesday, Mar 4, 09 @ 6:49 am:

    If the current market downturn lasts for years, and forces government agencies to live within their means (and pay for their mistakes), I will call it a great success.

    Another decade or so of prosperity, we would have been completely enslaved.

  2. - Bookworm - Wednesday, Mar 4, 09 @ 7:15 am:

    Oh heck, I figured long ago that I’m just going to have to keep working until I die since I can’t count on Social Security or pensions of any kind to be around. I do have a small annuity left over from a former job, which of course has also tanked with the stock market. I work for the state but I’m certainly not counting on that pension (I can’t retire for at least 20 more years). Call me a sucker but if my pension benefits had to be cut back and I had to pay more for my healthcare, I wouldn’t complain. I’m not counting on it anyway.

  3. - South Side Mike - Wednesday, Mar 4, 09 @ 8:10 am:

    If Chicago manages to blow the deadlines for submitting stimulus projects, that could be the final straw that gets Daley the boot. Yes, I see Daley going down if that happens. (Sadly, I can see the State bungling at least one of the deadlines). However, I’m very disturbed about the secrecy of Daley’s list (for he fears it will get panned by the papers and other media). Well, if the only stimulus is more wrought-iron fences, hell yes, you will get blasted. Opening up the list could have started a debate that produced even more worth-while projects, even if they aren’t managed or controlled by Daley’s best buddies. But therein lies the rub. Sometimes Daley is bull-headed because he truly believes something is in the best interests of Chicago. Other times, he’s bull-headed because it benefits him or his friends. This is looking a lot like the latter.

    As for the CTA pension fiasco, that agency has chronically been mismanaged by the Board, and its become exceptionally bad under Brown. She needs to go. The negative arbitrage is just the latest of “oops!” moments for her.

  4. - Anon - Wednesday, Mar 4, 09 @ 8:19 am:

    Slightly off topic:

    Report: Daleys flew on non-profit’s luxury jet
    March 4, 2009 8:06 AM | No Comments

    A non-profit company under investigation by the IRS and Congress used its $31 million jet to provide flights to Mayor Richard Daley and other high-profile figures, CBS News is reporting.

    Educap, a multibillion-dollar student loan charity, jetted Daley and his wife, Maggie, on 58 flights to destinations including Turkey, Asia and Sweden, CBS reports.

    CIA Director Leon Panetta, former Sens. Tom Daschle and Ted Stevens, and former FBI Director William Sessions also took flights on Educap’s jet.

    Educap is being investigated for alleged abuse of its tax-exempt status, CBS reports, because it charges high interest on charitable student loans and provides lavish perks to its CEO.

  5. - Hoping For Rational Thought - Wednesday, Mar 4, 09 @ 8:43 am:

    Rich - I would have expected a report soon from COGFA on pensions. They really should report on where we are at with the $10 billion bonds.

    At some point the GA and Gov. are going to have to find a way to change pensions for future state employees. It isn’t sustainable because it is too easy to pass the buck down the road. Something has to give. A tax increase is hard but especially when looking at the pension problem which was created by GA after GA taking the easy way out.

  6. - 3 beers to springfield - Wednesday, Mar 4, 09 @ 8:52 am:

    If Illinois misses the deadline for submitting projects to the Feds, it won’t be because local governments did not meet the deadline for submitting projects to the State. Municipalities, counties and regional planning authorities began submitting projects the day after the Bill was signed. And I’m sure I read a list of State projects that are being submitted to the Feds. Of course, it’s Illinois, so all projects must go through “political vetting” because we don’t submit projects by order of importance but by order of importance of the person in whose District the project is located.

  7. - Pat collins - Wednesday, Mar 4, 09 @ 9:03 am:

    Referring to CA public pension fund:

    Its annual return during the decade from Dec. 31, 1998, to Dec. 31, 2008, has been 3.32 percent,

    That’s better than Vanguard’s Balanced fun index, which is 0.90% over that time.

    But, the cause is just “over predicting”. If a football coach bet on getting 3 or 4 long bombs each game, you would know he is goofy.

    So why accept it when a legislature or gov agnecy does so?

  8. - VanillaMan - Wednesday, Mar 4, 09 @ 9:16 am:

    To all those out there who wish this can just be taxed away - take a look at the sheer incompetence our current state government is exhibiting! You want us to pay more for this?

    You want government to become the shared savior of everyone who needs help? Look! They cannot even do the simplest tasks!

    From health care to education, from roads to state parks, from pensions to paychecks, we are witnessing that government doesn’t know what it is doing, and worse, ruining those entangled in it.

    You want us to pay for this?

  9. - ShyBoy - Wednesday, Mar 4, 09 @ 9:20 am:

    Why would they be waiting for a list from Chicago? Isn’t the state capitol still in Springfield?

  10. - Anon - Wednesday, Mar 4, 09 @ 9:24 am:

    Outsourcing - that’s what Shared Services was supposed to do. Actually outsourcing, like the FOID card? Those jobs go out of state due to Illinois’s minimum wage law - the Procurement Policy Board has wrestled with this issue already. To quote Rich, “try again.”

  11. - Anonymous45 - Wednesday, Mar 4, 09 @ 9:39 am:

    Alls I can say is GO FRIARS!!

  12. - Cousin Ralph - Wednesday, Mar 4, 09 @ 9:41 am:

    It will only get worse. Wait until next year when countless cash-strapped and nervous Illinoians protest their property taxes to have them reduced dramatically downward to reflect their loss of value. Counties, schools and other local and regional taxing bodies that rely on property taxes for funding are going to find themselves in serious trouble. Either the residents pay taxes on inflated values or the rates are adjusted downward to reflect the actual depreciation in value of real estate. Sooner than many think, the question will not be can we tax Illinoians more, the question will be how will a smaller and smaller collected-tax-revenue pie be divided among state and local entities, few of which have any plans other than growing. And as the Bloomberg article demonstrates, government borrowing to pay current expenses will not only be ill-advised, but probably also impossible. They will have to pay junk bond rates because their ability to pay will be scored as questionable by bond rating agencies. The biggest buyers of govt. bonds, banks and pension funds, will not be able to buy much given the risk. The only govt entities that will be able to sell bonds will be those that have acted in a fiscally responsible and prudent way for years. Illinois, Cook County, Chicago and many other such entities in Illinois do not fit that discription.

  13. - jerry 101 - Wednesday, Mar 4, 09 @ 9:42 am:

    for the city to have failed to submit a list of projects is just plain stupid.

    I can submit a list of projects right off the top of my head…
    CPS - we have a raft of old schools that need to be refurbished and modernized. There are a number of latino neighborhoods with huge overcrowding problems as well.

    CTA - Upgrades - More new hybrid buses and replacements for the creaky old accordian buses. The worst train cars are being replaced starting next year (the orders were placed a while ago, delivery starts next year), I believe, but there is still a need to replace the subsequent generation of cars, which are way past their useful lives and costing CTA tons of extra cash for repairs and maintenance. Then there’s new investment - Red line extension and the circle line have been in planning for years, but lacked funding. Not to mention pie in the sky-esque plans like extending the CTA to Woodfield and/or the Oak Brook Mall. Not to mention extending the Skokie Swift to Old Orchard.

    The city itself needs to refurbish several more subway stops (City owns subway stops, CTA owns elevated platforms). And there are streets and sidewalks all over the place that need to be rebuilt.

    The state has a better excuse for not having it’s list ready with the changes in the executive branch, but the professional civil servants should have had their wish lists ready to go as soon as the stimulus was announced, regardless of who is governor.

  14. - wordslinger - Wednesday, Mar 4, 09 @ 9:44 am:

    –The one group that benefits from the pension bond sales is the CTA’s retirement plan members..–

    Have to quibble a bit here. The underwriting network, bond counsel, financial advisors, etc., all get a nice taste in the “costs of issuance.” Even the actuary who advised against made some nice change.

    I’m sure the fact that the actuary and auditor general did advise against it is one reason the bonds priced so high.

    The muni bond industry is a very small and close group that makes very good money for not a whole lot of work at very little risk to themselves. They’re world-class bundlers for campaign contributions and every firm has a clout-heavy local make it rain.

    Negotiated deals, which are unnecessary except in the most complex debt offerings, ensure that the business gets spread around and everyone gets a taste.

  15. - James the Intolerant - Wednesday, Mar 4, 09 @ 9:48 am:

    Frank Kruesi tended to take a lot of grief for projects that were approved by the CTA Board, like the Block 37 fiasco, and the Board gets a pass. And who was in charge of the CTA in 2007 when this occurred, Ron Huberman. They will be cleaning up after his mess; mis-use of capital dollars (while it is nice to repair Blue Line slow zones, don’t use every capital dollar available to do it), outsourcing real estate @ $800,000/year, hiring all his cronies at $100,000+ per year; for years.

  16. - wordslinger - Wednesday, Mar 4, 09 @ 9:57 am:

    I did’t realize that Quinn’s brother was the Fenwick coach. He’s a good coach and runs a classy program. I catch their games when I can — including three straight wins the last two years by the Oak Park River Forest Huskies at a sold out and rocking OPRF Field House :)

    Fierce community rivalry and good, clean fun for two great schools located four blocks from each other.

    I saw Young play OPRF in a playoff thriller last year at Proviso East. Believe me, the security around Jordan was a lot tighter than anything Quinn will experience as governor.

    Another reason to cheer up — March is here and the basketball means something. Selection Sunday is week after next!

  17. - Honest Abe - Wednesday, Mar 4, 09 @ 9:58 am:

    Shovel ready projects?

    How about mailing a postcard to the Feds with the words: “Filling Chicago’s potholes” written in with a Sharpie?

  18. - Cassandra - Wednesday, Mar 4, 09 @ 10:15 am:

    Since we now live in Bailout Nation, public retirees shouldn’t worry too much. The feds will borrow more money from the Chinese and make those state and local retirement plans whole should they demonstrate major teetering on the brink. We’re going to give $150 billion to AIG and let a bunch of old folks move into poverty? I don’t think so. That first major financial bailout changed the whole game.

    While they are at it, since the majority of today’s employees are not covered by defined benefit pensions, the Feds should borrow some more and set up a national savings plan for all so that not only the public employees (and the shrinking number of private sector employees with private sector pensions )will avoid the poorhouse. As we’ve seen recently, saving your money just doesn’t do it.

  19. - downsized - Wednesday, Mar 4, 09 @ 10:20 am:

    You must be new to the area :)

  20. - Amy - Wednesday, Mar 4, 09 @ 10:27 am:

    what no shovel ready list from the State? come on Jack Lavin, you are supposed to be cracking the whip on the stimulus money.

  21. - Pot calling kettle - Wednesday, Mar 4, 09 @ 10:44 am:

    I fail to see how outsourcing really saves money:

    First, the contractor takes a profit. So, if the contractor can still work for less they are cutting corners or cutting the worker’s wages neither of which is a good idea, OR the state has too many people doing that task. If it is the latter, we need to cut some state jobs. Cutting back on headcount is not popular with the unions, but it is better than losing the work to contractors.

    I reject the idea that a private firm can do better work for less money. If that is so, there is no good reason why the state cannot do it for even less, since the state is not for profit.

    The response will be that a private firm can hire cheaper labor, but is that really where we want to go: more low paying jobs with no benefits? In the long run that lowers tax revenues (sales, property, income) and puts more people into state-funded programs that assist those with low incomes. So much for the savings.

    It’s time for the citizens of Illinois to pay for the services they demand from the state.

  22. - Six Degrees of Separation - Wednesday, Mar 4, 09 @ 10:55 am:

    IDOTs list of shovel ready projects has been public info for a week or so. The locals are also vetting their projects through IDOT, although they aren’t under the gun with the ARRA rules like the state. Only reason the list hasn’t been officially delivered to the feds? Remember this is a state budget issue, since the state has to upfront the money. There is a short window for horse trading, and we are in it now, but the time is getting very short.

  23. - Truthful James - Wednesday, Mar 4, 09 @ 11:26 am:

    “…“We executed the best transaction we could, given the legislative and political restraints,” says CTA Chairman Brown, who is also co-head of municipal finance at Chicago-based Mesirow Financial Inc….”

    Investment bankers scratch each other’s back. The deal was one of the “barely make sense” but we make a bundle” deals that the bankers and the rest of the cohort love.

    Chairman Brown’s firm should not participate in any future deals (as co-manager, etc) underwritten by the winning bidder in any CTA Bond deal.

  24. - Anonymous45 - Wednesday, Mar 4, 09 @ 11:31 am:

    There is a Transportation meeting on Friday @ CMAP
    ostensibly to finalize and get public input on projects…be there and keep yer mouth shut until then…conclusions on this subject are a wee bit premature…

  25. - Scooby - Wednesday, Mar 4, 09 @ 12:31 pm:

    Sooner or later an enterprising reporter is going to start calling up the pension funds and ask them what happens when you invest your securities lending proceeds in Lehman and then they go out of business.

  26. - steve schnorf - Wednesday, Mar 4, 09 @ 12:31 pm:

    As to pension bonds, I suspect that the state’s big pension bond issue is under water right now. I’m down at least 50% in the last couple of years, and anyone who is in equities is down also. On the other hand, the first two or three years the initiative seemed genius like, as the market boomed.

    But three year or two year snapshots aren’t really the question, its what will it look like over the life of the bonds. Over extended periods of time, well run pension funds earn 8% or more. Measure rolling ten years at a peak and they earn 15 or 16, measure at a trough and they earn 2 or 3, but as I said that isn’t the point.

    The 8.75 actuarial assumption is almost certainly at the high end of public pension funds’ assumptions. I would bet that the predicted chance of success by their consultants would have gone up remarkably at 8%, or even 8.25%.

    And, they got unlucky on what they had to pay. They could just as easily ended up at 6%. But still, if they average 8 over 30 years, and they paid 6.8, its still is a good deal, just not as good as it could have been, based on timing. And, sometime in the next 5 years they will probably get a chance to re-finance and drop their costs.

  27. - Fly on wall - Wednesday, Mar 4, 09 @ 1:06 pm:

    I’m with Steve, again.

    What the Bloomberg article doesn’t say is that 1) the General Assembly required the deposit of $1.6 billion in funds, effectively as compensation for lower retirement benefits. This was the price of those concessions; and

    2) the Auditor General (as required by the General Assembly) increased the interest rate and the costs of issuance dramatically by insisting on a long, drawn-out review process and taking months do so.

  28. - Cook County Commoner - Wednesday, Mar 4, 09 @ 2:21 pm:

    The CTA Pension Plan is probably just the canary in the coal mine. The Illinois Division of Insurance 2007 report on pensions reports that there are over 600 public employee pension plans in Illinois. Judging from reporting from across the nation, most government employee plans did the same as Illinois state and local government plans: overestimated returns, over promised benefits and under contributed. Numbers upwards of $1 trillion are ciculating as what will be needed to ensure early retirement at 50 or 55 at 80% of salary with full healthcare to these government workers. Getting a straight set of figures out of all the government employee plans in Illinois is unlikely. But you can bet where a good chunk of any new state and local government tax revenues will be going, along with any stimulus dollars from the feds.

  29. - Truthful James - Wednesday, Mar 4, 09 @ 3:03 pm:

    C.C. Commoner:

    “…ensure early retirement at 50 or 55 at 80% of salary with full healthcare to these government workers…”

    This is an outrage. Those good soldiers and sailors who are thrown into harms way in Afghanistan and Iraq would dearly love to get this good a deal.

    steve —

    what a bunch of assumptions and subjunctives…don’t forget that in the low rate of return years, they are reinvesting at that low yield as well. And who is to say in the future that it will go up to 15 or 16 on allowable investments as you suggest?

  30. - Marianne North - Wednesday, Mar 4, 09 @ 3:42 pm:

    Maybe in Cook County you get 80% of your salary for pension. Here at IDHS, we get 50% under the Rule of 85 and 50% was an increase AFSCME got for us around 14 yrs ago. We get free health insurance after 20 years. I would rather take that but the state has been whittling away the health insurance coverage over the past 8 years. Chicago Public school teachers get 75% of their salary after 30 years but they pay an exorbitant amount for health insurance.

  31. - Arthur Andersen - Wednesday, Mar 4, 09 @ 4:27 pm:

    Truthful, there is much more to the equation than “reinvesting at that low yield.” Buying in a down market, assuming manager skill (which is a big assumption, I’ll grant you) is the best time to capitalize on market inefficiencies, mispricing, and to acquire assets of all types which have the potential to appreciate as the market recovers.

    A quick example: most of us here in Central IL probably aren’t worried about ADM going BK or becoming insolvent anytime soon. Recently, one could buy ADM convertibles (bonds, not cars) due in 2011 with an equivalent yield of 11.5% due to the price decline of the bond during the overall bond market turmoil of 2008. Not too shabby, and not too risky.

    History tells us that markets go down, and they go back up.

    The State’s pension systems have all reported double digit annualized returns over the past 25 years, including 2008.

    The CY 2008 and FY 2009 returns won’t be pretty. Expect negative 20%-plus for the CY.

    The pension bond monies were above water until just a couple of months ago from what AA has heard.

    Scooby-your enterprising reporter should go nose around that CTA POB deal. Two or three days’ worth of story up there.

    Your other tip is only exciting if you’re a bond geek. Oh, and BTW, it’s “securities lending collateral,” not “securities lending proceeds.” What happens is the provider makes the clients whole with other collateral or ends up in court.

    As an aside, the investment expert Kramer from New Jersey quoted in the story must be related to Cosmo Kramer from Seinfeld. He thought it was a good idea to invest $150 million of the Jersey pension money in Lehman Brothers stock 4 weeks before the firm tanked.

  32. - Chris Lawrence - Wednesday, Mar 4, 09 @ 5:48 pm:

    The truly scary thing to me is that until IL bans campaign contributions from both corporations and unions, there is little to no hope that our legislature will confront the vested interest that fund their campaigns, and honor their fiduciary responsibilities for the common interest. This is a ticking time bomb that could, and in all probability will, prevent the next generation Americans to fund the necessary public expediters in public safety, public education, public infrastructure, and public health that have allowed this nation to be become the wealthiest in history. It is one of the most selfish, self-serving, and failures of leadership in our nations history - and the longer we allow our public officials to attempt to ignore or paper over the enormous threats that under-funded liabilities and entitlements are presenting to this nation.

    The only thing I find even more scary, is what is going on in Pakistan and Mexico - and our utter unwillingness to be candid with American people with the kind of challenges we are facing at all levels of government.

    I hope you focus like a laser on this issue - it will not be solved any time soon, but it needs to be addressed.

  33. - wordslinger - Wednesday, Mar 4, 09 @ 5:54 pm:

    AA, on the CTA deal the gang was all there, that’s for sure, including Morgan Stanley, where young Bill Daley is a public finance banker (add their boilerplate disclaimer on how he doesn’t work on Chicago business here).

    It’s a sweet racket. Case in point: When this bond deal was being put together, Carole Brown was the CTA Chair. She was also a managing director at Lehman, seeking to drum up muni finance business from the City of Chicago, State of Illinois, Chicago Park District and Chicago Board of Education, among other Midwestern debt issuers, according to her online corporate bio.

    So on one hand, she’s the head of an Illinois public agency that’s putting together an underwriting team for a $2 billion public bond issue. On the other hand, she’s a managing director at a firm seeking to join underwriting teams for public bond issues by Illinois governments.

    Anyone see a potential for conflict of interest? Bueller? Bueller? Bueller?

    One of the financial advisors on the CTA deal was Mesirow, where Brown used to work. A couple of months after the bonds were issued, Lehman’s on the rocks; a couple of months after that, Brown rejoins Mesirow as a senior managing director and head of its public finance and tax-exempt capital markets divisions.

    The argument you’ll get from those in the business is that the community is so small, that you can’t help but do business with your friends if you move between government and public finance (or in this case, stay in both at the same time). And as we all know, it’s good to have friends.

  34. - Truthful James - Wednesday, Mar 4, 09 @ 5:58 pm:

    AA –

    What we are looking at is rather a huge problem which occurred when the Housing (and household spending which has come to represent an abnormal (and abhorrent) share of GDP in the absence of the formerly dominating industrial sector shifted of what I would call a normalized long wave curve of increasing value. and started to increase at at a rate higher than the increase in personal incomes.

    Demand was increased substantially through regulatory measures. Accordingly, builders increased supply, The combination brought a false prosperity that could not be maintained.

    It became a political mantra to make home ownership the objective for a larger and larger percentage of the population. (We had tried this once before in the 1970 era with the FHA 222 and other programs which had little or no money down. They tanked and created new Chicago slums and litigation.

    We started again in the 1990s with the Community Reinvestment Act, whose authority was widened. Financial institutions making mortgages were put on notice in the original act that they had to make positive efforts to avoid the threat of discriminatory practices. The institutions responded by making more non conforming (what were later called - subprime) mortgages With the revision of the Act, Fannie and Freddie were able to package them into pools of securitized mortgages and back them with their credit.

    One of the most interesting points of which I was not aware is the fact that the regulatory permission to securitize sub prime mortgages was not given until 1997 in that revision of the Community Reinvestment Act.

    The investment bankers decided to mimic Ginnie, Freddie and Fannie and do pools themselves, sweetening them with insurance from the Bond insurance companies (making them investment grade) or putting on Credit Default Swaps using there own AAA credit or buying that rating from AIG and others..

    Nobody took any cognizance of the variance from the normal increase over time in housing values and the fact that it must return at some time to the normal curve. That meant that housing values would have to level off or fall.

    A second hiccup was the decision of the Fed to play with the key borrowing rate. The Federal Funds Rate (a
    short-term interest rate) was slashed from 6.25 percent in 2000 to below 2 percent by 2002. This was followed by by a shift in Fed policy. From 2004 to 2006 the Federal Reserve ratcheted up the Federal
    Funds rate to 5.25 percent,

    The rate on mortgages shadowed the Fed rate movements. The pools of mortgages — the mortgage backed securities — were issued with a yield which reflected mortgage rated of the individual pieces.

    Mortgage backed securities became subjected to a “Mark to Market” rule. Consider what this does to the mortgaged backed securities. Whereas, a pool of, say, 3% mortgages were originally issued when the Fed Funds rate was at 2% at a price of 100 and so reflected on the books of the institutions. When the market price of new .pools containing 6% mortgages is priced at 100, the institution holding the 3% pool must mark its value on the books to some price well below 100.

    Now an institutional balance sheet must indeed balance. That asset is balanced by a combination of debt and equity on the other side. Since liabilities can not be shed, the value of bank’s equity must fall. and thus, other things being equal, its share price. All because of the Mark To Market Rule, which works well with frequently traded securities but not with securities held for long term in an institutional portfolio.

    I look for the normal curve to be reached after the huge inventory of unsold houses falls no average levels That is not going to take place, in my view until well into 2010.

    Turning from the market to the households, there is an equilibrium level of savings which includes on the one hand the savings embedded in the increase in housing values, and the savings or dis-savings related to bank balances and the use of installment debt (credit cards) and auto loans. As long as housing values rose, households could afford dis-savings and bought (depreciating) consumer goods. Indeed, they used some of the embedded value in the homestead to pay for the dis-savings through refinancing or home equity loans.

    When housing prices started to fall the normal reaction was to slow the dis-savings rate by paying down consumer debt or postponing consumption in an attempt to restore equilibrium. When housing values dropped below the mortgage amount, they acted rationally if impatiently and abandoned the homestead which was the greatest monthly outlay.

    Both Bush and Obama have tried to open the banks vaults and inspire (because they have failed to require) lending. Buying huge amounts of toxic assets, investing billions in bank and AIG stock has maintained the status quo at great expense. They have been guessing with your grandkids money.

    Finally, Obama may be seeing it correctly. What has to happen is wherever possible make mortgages good mortgages with a principal amount which makes payments and borrower income qualify under standards. The lowering of the mortgage amount means that the institutions will have to keep an equity position of the difference between the old and the new mortgage, and the fed can guaranty that equity position only, buying where necessary.. It won’t work for all, but it will have an effect on the securitiaed mortgage portfolios and the credit default swaps.

    Good mortgages means every owner will have lower payment, which will enable him to save or spend, releasing money into the economy. What they buy is key. Domestically produced goods need to be manufactured. Buying from China through Walmart will enrich both to the detriment of the American economy.

    All of which goes to say, 8.75% returns in a steadying economy for the pension funds ias a very long way off.. As long as the inflation rate stays low, across the board the cost of financing and the return from investment will remain lower. For certain the inverse position (2% Treasuries versus 6% tax exempt municipals) will be reversed.

  35. - Mike Ins - Wednesday, Mar 4, 09 @ 7:19 pm:

    “The argument you’ll get from those in the business is that the community is so small, that you can’t help but do business with your friends if you move between government and public finance (or in this case, stay in both at the same time).”

    I think that is the key there. This really boggles my mind. How is such an arrangement ethical? Legal? Moral?

    Even with all the dubious back-and-forth between regulator and regulated and the “regulatory capture” that entails in practice.. in this instance it is, as I see it, simultaneously:

    (1) The CTA Board rejects Auditor General of Illinois recommenation;

    (2) The CTA Board rejects the recommendation of its own outside actuarial firm;

    (3) The CTA Board, against all advice and counsel, determines to do a bond issue;

    (4) The leader of the CTA Board making the decision CURRENTLY works in the industry. Not “worked in the industry”, not “hopes to work in the industry”… BUT CURRENTLY WORKS IN THE INDUSTRY.

    … look, whether the bond deal in 20 years turns out to be an abject failure or a rousing success, I dont know. Carole Brown does not know. The AG and actuaries thought most likely it wouldnt be, but that is irrelevant.

    It actually makes me sad.

    How many days until the next CTA “doomsday”?

    Something to think about as I am on the 151 this evening.

  36. - Arthur Andersen - Wednesday, Mar 4, 09 @ 10:46 pm:

    Truthful, there’s a lot of truth in your post. The State funds’ hundle rate is 8 to 8.5%, not much less than the CTA, but every bp is valuable in the current environment.

    The task for institutional investors of all types right now is to not try to chase performance by investing in what worked last year, but to continue to adapt a long-term portfolio that considers that certain sectors of the capital markets have been repriced. This means fewer equities, fewer Treasuries, more high-quality munis and corporates, TIPS, commodities, real assets, and absolute return assets.

    word, great post. Reminds me of the time when the State POB cash was about to be doled out and Filan ordered the pension funds to a meeting at Mesirow. After having a couple “outside experts” make remarks about the economy, he cuts to the chase and says that he believes the whole shebang should be invested in short-term bonds and hedge funds, wherein the “host” from Mesirow, one of the “financial advisors” on the POB, stands up and says, “we happen to sell hedge funds” or something to that effect.

    Hey, here’s another story for Scooby’s enterprising reporter: call up the people who testified that a $26 billion (2007) or $16 billion (2008) Illinois POB would be a swell idea
    and see what they have to say now..

  37. - steve schnorf - Wednesday, Mar 4, 09 @ 10:46 pm:

    TJ, only a hundred years of history, and its all any of us have to go by.

    BTW, if pension funds make no bad investments, they probably aren’t taking enough risk.

  38. - Truthful James - Thursday, Mar 5, 09 @ 7:59 am:

    “The argument you’ll get from those in the business is that the community is so small, that you can’t help but do business with your friends if you move between government and public finance (or in this case, stay in both at the same time).”

    That’s a specious argument. There are enough banking firms at the mega level so that a loss of one on a four year restriction should not matter.

    Do you really think that they came to the entity employment and Board positions out of a sense of pure altruism?

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