By: Mark Glennon*
Bailout folly was sure to be on the table. With markets down about 25% from their recent highs, pension funds are taking a beating, and ideas for bailing them out are brewing.
The first specific proposal we’ve seen would be a three-fer, piling wrong on top of wrong on top of wrong. It’s from the Rockefeller Institute’s Liz Farmer, published nationally and in Crain’s Chicago Business.
That idea is for state and local government to issue bonds to borrow money for pensions. They are called pension obligation bonds, or POBs, which we have criticized repeatedly at Wirepoints. And the proposal is to make those bonds tax exempt, meaning federal taxpayers would subsidize them.
First, POBs are inherently foolish. They represent nothing more than borrowing to cover debt — one credit card to another — replacing unfunded pension debt with unfunded bond debt. They are a can-kicking at its purest.
Worse, they gamble that interest paid on the bond will be less than earnings made on the stocks a pension would buy with the borrowed money. Farmer says “a boost in assets now would likely produce a welcome return on investment over the next few years and ultimately help stabilize government pension bills.” That’s pure speculation, and nothing more than market timing, an investment strategy widely shunned as a suckers’ game by pension managers and all but a few experts who specialize in it. Basic market economics say that the likely return on stocks and bonds, if properly risk adjusted, should be equal.
Who would buy those bonds from Illinois, Chicago and others that were in death spirals even before the current downturn? Therein lies the second wrong in Farmer’s proposal. She says the deal could be sweetened by making interest on the bonds exempt from federal income taxes. That would be a backdoor way to force all Americans to pay for a bailout, including those in responsible states that have managed their pensions sanely.
The final problem with Farmer’s suggestion is she omits any conditions that should be attached to federal help. In our view, any open-ended federal assistance for state and local governments, and any direct assistance to pensions, should be conditioned on pension reforms in the states that need it. See our new column in RealClear on that. Under no circumstances should federal money go towards the futile hope of filling the bottomless pits of the worst-managed pensions in Illinois, New Jersey, Connecticut and certain other states.
That reform condition must apply to other bailout ideas in the nature of block grants, general notions of which are now percolating.
House Speaker Nancy Pelosi wasted no time after passage of the $2 trillion emergency appropriations last week, saying she wants another bill that would include direct assistance to state and local governments as well as pension assistance. And Illinois Senator Dick Durkin had already tried to insert straight cash bailouts in the bill passed last week.
The Federal Reserve Bank is also reviewing new ways to support financing for state and local governments, as nicely detailed by the Wall Street Journal last week. The Fed has already begun some purchases of short term obligations, though just to calm the market in municipal finance. Among the questions Fed is now considering, according to the Journal, are whether to expand existing facilities to accommodate other municipal debt or to launch a new facility devoted to state and local finance.
“The states and localities that need the most help are the most risky by definition,” said an economist quoted by the Journal.
That is precisely the problem with potential aid from either Congress or the Fed. If that aid goes where it is most needed it would bail out the most fiscally irresponsible states and cities. Fairness, however, would demand that it go pro rata based on population and help should be conditioned on reform in states that have refused to reform.
*Mark Glennon is founder of Wirepoints.