Surf City is risking a fiscal wipeout if it approves a proposal for pension obligation bonds.
According to the Government Finance Officers Assn., POBs are taxable bonds that state and local governments can use “as part of an overall strategy to fund the unfunded portion of their pension liabilities by creating debt.” However, POBs involve considerable investment risk.
The concept is simple. It is like paying off a flexible credit card balance with a 25-year fixed mortgage. However, there is more than the mere switching of lenders.
On Nov. 18, the Huntington Beach City Council adopted a resolution to use POBs “to refund all or a portion” of its unfunded actuarial accrued liability, or UAL, to CalPERS — the California Public Employees’ Retirement System. The resolution started a judicial validation process for the POBs.
According to the request for City Council action prepared by Dahle Bulosan, acting chief financial officer, the council’s next actions in March or April would “include approval of the preliminary official statement, identifying a not-to-exceed interest rate for the bonds, as well as the underwriting discount.”
According to the city’s analysis, Huntington Beach is choosing to use POBs because it is being charged an interest rate of 7% to service its UAL debt load.
The annual cost to the city budget due to the UAL rose from $4.58 million in fiscal year 2009 to $24.93 million in 2019. It continues to rise and the city’s analysis projects it will double to $46.02 million in 2031.
The city’s analysis warns that, to pay for these costs, Huntington Beach will need another $21.09 million a year by 2031. That could mean drastic cuts.
We sympathize. As the Daily Pilot reported in June, the city is still recovering from “recession-related cuts.”
Market interest rates are still low. The POB would replace a 7% interest rate with CalPERS, which can be flexible with its annual required contributions. Bondholders would require a maximum interest rate of 3%, requiring a fixed payment schedule. The city could save $8.5 million per year.
On the other hand, the Government Finance Officers Assn. also warns that POBs are very speculative.
In 2012, CalPERS cut its assumed rate of return from 7.75% to 7.5%. CalPERS cut it again in 2016, to 7%.
Warren Buffett recommends using a 6% assumption. Pension expert David Crane of Stanford University says 5% is a more realistic goal for public pensions. In other words, instead of supposedly “saving” 4 percentage points with POBs, Huntington Beach might “save” only 2 percentage points.
In dollar terms, that could mean “saving” $4.25 million a year, instead of $8.5 million.
In addition, making the 7% annual return, with current low inflation and low fixed income yields, means CalPERS is motivated to invest in riskier securities to offset those lower returns in its overall diversified portfolio. With this exposure, if the CalPERS fund were to take a significant market loss, the HB proceeds in the portfolio would suffer the same loss.
Interest payments on the POB debt are not reduced even if the bond proceeds paid into the CalPERS fund have lost value, making this arbitrage strategy a gamble, more so as the equity market is currently at an all-time high.
This scenario is reminiscent of the 1994 Orange County bankruptcy.
Back then, former county treasurer-tax collector Bob Citron used reverse repurchase agreements, a similar arbitrage scheme to POBs, which also “guessed” that short-term interest rates would stay low. As a candidate for office, Moorlach warned in the June 1994 election that this was a dangerous strategy that could bring disaster if short-term interest rates started rising, meaning they inverted.
That is what happened. The rest is a sad chapter in Orange County’s history.
Refinancing a debt should be a prudent strategy, but borrowing to invest brings unforeseen risks for losses. Hoping the CalPERS assumed rate of return is not reduced down to 3%, which it should do over the next 25 years, may not be a reasonable forecast to rely on.
In addition, hoping the Dow Jones market does not drop below 28,000 in the next quarter century may reflect a lack of understanding of economic cycles.
Converting a soft debt into a hard debt, with bondholders unwilling to make payment schedule adjustments, may come to haunt POB issuers in the future.
No wonder the GFOA warned that, “In recent years, local jurisdictions across the country have faced increased financial stress as a result of their reliance on POBs.”
Surf City needs to avoid a potential wipeout, as a few bad economic waves can ruin its future cash flow.
John Moorlach (R-Costa Mesa) represents the 37th district in the state Senate. Shari Freidenrich is Orange County’s treasurer-tax collector.
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