CalPERS: Thinking the unthinkable

Last spring CalPERS doubled the amount of a program that uses the pension fund’s gold-plated credit rating to help state and local governments borrow more cheaply, moving the cap from $5 billion to $10 billion.

Now as the economy crumbles, CalPERS is taking a look at what seemed unimaginable last year: What happens if the government borrowers default on their debts and CalPERS has to repay the loans?

“In exchange for only a couple million dollars you are taking on a heckuva a tail risk,” Michael Schlachter of Wilshire Consulting told the CalPERS investment committee last week.

CalPERS earned $3.9 million last year as it guaranteed $748 million in loans, bringing its total commitment to back the borrowing of government agencies in California and other states to $2.3 billion.

When the program cap was doubled to $10 billion last June, CalPERS officials thought that troubles for municipal bond insurers and a tightening credit market could be an opportunity to earn more fees while providing a public service.

Schlachter said in a letter to a CalPERS investment official last month that the “credit enhancement program is one of the areas where we believe that CalPERS ‘does well by doing good.’”

A CalPERS board member who also is a Kings County supervisor, Tony Oliveira, said his dual role gives him conflicting views of the program. He asked the staff for a white paper on local governments and the risk for CalPERS in the credit program.

“I looked at the amount of yield versus the potential macro liquidity risk factor and it scares me,” Oliveira told the committee. “To be honest with you, I’m one that thinks it’s not worth it.

“On the other side,” he said, “I must tell you as a local government representative in California we appreciate it, because it helps, obviously. It facilitates.”

Schlachter said the risk of local governments defaulting on their debt is “very remote,” but should not be ignored. CalPERS staff said the credit program uses careful screens and is grounded in studies going back to the U.S. Civil War.

A senior portfolio manager, Arnold Phillips, told the committee that he is responsible for a type of investment that has not been served well by looking at history as a guide: mortgages.

“I think we really do need to look at this because it does appear in some sense we are in a new world here,” said Phillips. “So I agree 100 percent that probably this needs to be looked at, a white paper and so on, to really decide this.”

In the program, CalPERS issues a letter of credit or similar backing that allows a government agency with a lower credit rating to use the pension fund’s top rating, lowering the cost of the loan.

But the credibility of the ratings issued by the three major Wall Street rating agencies — Standard & Poor’s, Moody’s and Fitch — is being questioned for two reasons now, even though they continue to be used in the bond market.

The ratings agencies have been criticized for giving top ratings to complicated mortgage-backed securities that have since been declared “toxic,” a leading cause of the financial crisis.

Rosy ratings are said to have been given to the shaky financial products of firms that paid the rating agencies fees, pumping up their profits. There are reports that the rating agencies are under investigation.

“The story of the credit rating agencies is a story of colossal failure,” U.S. Rep. Henry Waxman, D-Beverly Hills, said during a congressional hearing last fall. His committee released messages exchanged by two Standard & Poor’s employees.

Rahul Shah said a deal is “ridiculous” and “should not be rated.” Shannon Mooney replied that the rating model “does not capture half the risk … We rate every deal … It could be structured by cows and we would rate it.”

Before the financial meltdown last fall, state Treasurer Bill Lockyer launched a drive urging the rating agencies to stop holding government bond issuers to a higher standard than corporations.

The treasurer said history shows that the government agencies are far less likely to default than corporations. He said the unwarranted lower ratings “cost taxpayers billions of dollars in higher interest rates and bond insurance premiums.”

Lockyer said the interest paid on a bond rated “A” was 0.38 percent higher than a “AAA” rating. He said the difference on $61 billion worth of 30-year California infrastructure bonds would be $5 billion.

Another Lockyer example of credit-rating costs: California paid $102 million from 2003 to 2007 to buy “AAA” insurance for bonds, which would not have been needed if the state were rated by the same criteria as corporations.

Some rating agencies appeared to be considering Lockyer’s complaint, co-signed by 10 other state treasurers. But a Lockyer spokesman said movement stopped when the financial crisis erupted last fall.

Then last month Standard & Poor’s, citing state budget problems, dropped California’s credit rating from “A+” to “A.” California had been tied with Louisiana, but now has the lowest Standard & Poor’s rating of any state.

“We know we have fiscal management problems, but a rating downgrade from any of these guys is tough to swallow,” said Tom Dresslar, a Lockyer spokesman. “Taxpayers are getting screwed by a rating agency that helped create the problem.”

In recent years, the state has made some use of the CalPERS credit program, which now backs two bond issues totaling $297 million. The state also has purchased backing for three bond issues totaling $549 million from the California State Teachers Retirement System.

The CalSTRS credit enhancement program began in 1994, about a decade before the CalPERS program. The next annual report on the CalSTRS program is expected in April.

In a quarterly report filed at the end of last year, the CalSTRS program said it was backing loans totaling $2.5 billion and had earned $3 million last year, bringing total earnings since the beginning of the program to $46 million.

CalSTRS had partnered with Union Bank to back one or more bond issues by the City of Vallejo, which declared bankruptcy last year. A Vallejo spokeswoman, Joann West, said the CalSTRS letters of credit expired and were not renewed.

But one of the top creditors listed in the Vallejo bankruptcy is Union Bank, owed $49 million.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Posted 6 Mar 09

7 Responses to “CalPERS: Thinking the unthinkable”

  1. Jeff Says:

    How much more cheaply are these government borrowings from the pension funds relative to what they would have to pay in the capitol markets? What are the actual rates? What are the lengths of the loans? If localities do go bankrupt, where in the order of claims do the loans stand?

  2. Dr. Mark H. Shapiro Says:

    I’d like to point out that throughout the history of the United States the default rate for municipal bonds rated by Standard & Poors has been extremely low — just 2.2% of the default rate for corporate bonds rated by the same agency.

  3. Dr. Mark H. Shapiro Says:

    During the Great Depression municipal bond defaults rose to roughly 16% of total state and local debt. HOWEVER, all but 0.5% of that debt eventually was repaid with interest.

  4. Namke von Federlein Says:

    Nice blog post. Thanks for offering this kind of quality information. Blog posts like this one help me develop my perspective in a positive way. I’m having a bit of trouble staying positive.

    @Jim Simkiss – do you have a reference for that 0.39% number?


  5. Namke von Federlein Says:

    @John becomes Jim becomes my brother Jim!

    Apologies for the name flub. And thanks for the reference! I’ve been wondering about this tax load distribution problem. All my old blogs are down but last year I was writing about the perfect tax storm.

    This is a new twist on the problem. A purely fictitious example to make a point : Taxpayer A pays 10 million in taxes in California. They move to Nevada and pay 5 million in taxes. Net effect : 5 million less in taxes. The top tax payers end up paying lower tax rates even as taxable income falls.

    I had been more interested in the off-shore effect. There is always a tipping point where Americans feel like traitors moving offshore but they just can’t take it. Figuratively : It hurts to see the huge waste and scams and then sit down a write a cheque for 10 million for taxes ‘yet again’ this year.

    It would be interesting see what the ‘cross State line’ impact will be on net tax revenues.

    All the best from old what’s his name 🙂

  6. Muriel Says:

    seems like there should be some attention to exactly what projects the local governments have in mind. one project may help retirees’ quality of life, or the local economy, in some other way, while another project may not.

  7. houston home mortgage Says:

    Just to let you know, your site doesn’t load well in the t-raoin browswer. Anyway, keep up the great posts. houston home mortgage

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