As the debate expands about pension obligation bonds (“POBs”), it’s useful to think about them through another lens: margin trading on stocks, and why that’s heavily regulated.
Much has already been written criticizing POBs for other reasons that I won’t repeat here. Instead, my purpose is to add another perspective on why POBs are a bad idea. POBs aren’t illegal because margin rules don’t apply to government entities, but they do violate the rationale behind the law, making them unwise and unsafe for the same reasons we limit margin trading in the private sector.
With POBs, a state or local government borrows money by selling bonds and deposits the money into an underfunded pension. Unfunded pension debt, in other words, is traded for bonded debt.
Chicago is currently considering a $10 billion pension bond offering. Earlier this year, the head of the Illinois House Personnel and Pensions Committee floated the idea of a massive $107 billion POB to address state pensions. Illinois earlier issued about $16 billion of POBs under Governors Blagojevich and Quinn.
The supposed rationale for POBs is pretty simple: The pensions will invest the proceeds in the stock market and earn more there than the interest cost on the bonds. Chicago’s Chief Financial Officer, Carole Brown, has been clear about that. She says Chicago’s interest cost per year on a pension obligation bond would be about 5.5% and pensions would earn 7.5% in the stock market, netting the city about 2% per year on its $10 billion bond. (The foolishness of such a bet should be obvious on its face, but that’s another matter.)
In the 1920s, the public borrowed heavily to buy into a roaring stock market, routinely borrowing 90% of the stock price. When the market finally tanked in 1929, the drop accelerated partly because investors were forced to sell to cover their margin loans, creating a vicious circle that’s widely seen as a major cause of the Great Depression.
To prevent a recurrence, margin trading has been curtailed by law since 1934. Today, regulations promulgated by the Federal Reserve Board govern the topic. Regulation T covers most individuals and Regulation U covers banks and most similar lenders making large institutional loans. For most investors, margin borrowing is limited to 50% of the purchase price, though the Fed sometimes changes that percentage to add or reduce liquidity and risk in the system. In addition, only certain, quality, liquid stocks can be purchased on margin.
If you’ve worked in commercial banking you know how strict the rules are. Violators face civil and even criminal penalties.
As a lawyer in that field in my former life, I know it’s a rule that gets drilled into your head: No loans to purchase or carry stocks unless you look closely at the regs and comply. That’s a healthy instinct with a sound basis in policy. Unfortunately, politicians don’t have that instinct.
POBs as just huge margin loans
Is a POB really like a margin loan that would be restricted under most other circumstances? Margin regulations generally apply whenever a loan is made for the purpose of purchasing or carrying stock.** That’s the whole point of a POB — the government borrows 100% of the cost of additional stocks it buys through its pension.
With POBs, the borrowing is by the government and the stock purchase is by the pension, but that doesn’t really change the reality that it’s just like a margin loan. In Illinois, our courts have made clear that the sponsoring unit of government isn’t just obligated to make pension contributions, but ultimately is directly liable for paying pension benefits. So, for purposes here, the government and the pensions are really the same entity.
To put it another way, suppose a pension just borrowed a massive amount of money outright to buy stock? That would be widely condemned. But with POBs, for the government as a whole, the effect is the same.
The consequences of POBs going bad are similar to margin loans going bad, just not as rapid
Suppose a unit of government and the pensions it sponsors are deteriorating further into insolvency, as Chicago and the State of Illinois unquestionably are. (A single chart shows that, linked here.) For Illinois, that deterioration has occurred despite its $16 billion of POBs.
No quick margin call hits pensions as they deteriorate, as can happen with ordinary margin loans, forcing a rapid liquidation of underlying stocks.
However, a similar result unfolds more slowly. As pension funding levels decline, pensions gradually sell equities and other longer term investments and replace them with shorter term, fixed income to assure availability of funding needed to pay benefits in the near term. Some Illinois and Chicago pensions have already begun making that reallocation.
Ultimately, as the pension approaches pay-go status, all its assets are liquidated.
Concurrently, the sponsoring unit of government is required to contribute ever more to its pension, which is essentially like a slow cash call non-compliant margin borrowers can face more immediately.
Those processes would accelerate very rapidly in a recession. Pension asset values would drop and the sponsoring government’s revenue would decline. Chicago and Illinois already admit to having structural deficits even on a cash basis, and even with the best economy in decades. A recession would be devastating, almost certainly forcing them to seek legislative authority to reduce their annual pension contributions, which has been their habit. The pensions would then deteriorate further. The downward cycle would accelerate.
And the next recession is inevitable.
Yes, POBs can conceivably work out well. So can margin trading. So can a trip to Las Vegas.
But politicians considering POBs would be wise to consider the history of margin trading and why it’s regulated.
*Mark Glennon is founder of Wirepoints.
**In the case of large commercial loans regulated by Reg U, margin requirements only apply if the loan is also secured by stocks “directly or indirectly.” Is that the case with POBs? That answer is less clear, but probably ‘yes,’ further reinforcing the notion that POBs are like margin loans. With POBs, the purchased stock and any proceeds of its sale are locked away permanently, in trust, in the pension. By locking the stock up in the pension, the government is effectively imposing a negative pledge on the stock, making the loan indirectly secured. Negative pledges are considered “indirect security.”