Saturday, December 13, 2008

To defease, or not to defease: more city debt wonkery

Wonk warning. If you can't name who the Finance Chair is for Pittsburgh City Council you don't want to read any more.

I have to admit, it's a little hard to make sense of the debate in the news over how the city plans to handle some of the cash surplus it has. As boring and esoteric as it may sound, the debate going on actually gets to several core issues of the city's financial future.

So to keep it simple (not). Lets try the cliff notes version first:
  1. City actually has a cash balance at the moment.
  2. Originally Mayor said a lot of that extra cash was going into the pension fund. It was going to be 15% above the minimum just a few months ago.
  3. Then that got changed to pay less extra into the pension fund, but to pay down more debt. So in the end it was only 5% above the minimum this year (which is actually where the minimum will be next year anyway which itself does not begin to reflect the recent losses in the pension fund, more on the later).
  4. Then in budget presentations, the plan became to not exactly pay down debt, but to set aside an amount for that purpose.
  5. Debates arose as to what that means to set aside cash in that way. Is it legally possible to set aside cash that can not be shifted in the future to other things?
Got that? Who cares right? First off, why was the plan shifted from paying down pension funds to paying down debt? There would be no issue at all right now if the surplus in question was put into the pension fund where it could not be extracted. The city's debt level has not changed from its planned trajectory in the last year, yet the pension fund has been hard hit by the financial markets. You would think that the pension fund is far more in need of shoring up right now. I can only speculate the reasons for the shift, but suspect the mayor's budget reflects some of the preferences of the ICA. Without rambling more, I think the whole issue comes down to some key legal questions that I addressed when musing on the ongoing bankruptcy proceedings in Vallejo California. If you want more see what I said in Why Vallejo Matters.

But hold that thought and let's just look at the issue at hand of setting aside cash to pay off debt in the future. I'ts an odd odd debate for a lot of reasons. There is nothing at all strange about paying down municipal debt. The defeasement of municipal debt happens all the time and is a well understood process. The process involves creating an escrow fund, typically buying government bonds in an amount that will pay off future payments due on extant bonds and voila, you have effectively paid down debt even though the original bonds are still out there making payments to bondholders. As best I understand from the news accounts, there is no thought of doing this normal defeasement, otherwise there would not be this convoluted debate. So in a sense, this whole debate ought not to be happening.

Given that,why is there this debate going on about whether the surplus cash be set aside in some unique way, possibly under the control of a third party like the city controller? This is speculation, but there is a real problem out there in the debt markets which may not explain this. It may not be the explanation, but even so it would be a real problem if they really did want to defease debt the normal way.

The city's extant bonds are mostly at rates say between 4-6% (I'm too lazy to look up the specifics but it's something like that off the top of my head). Given all the other things going on in the economy (impending depresion and the like) one result is that most government bonds are at all time lows. Some T-Bills are now literally yielding zero percent!! So the potential bonds one would invest escrow funds into to pay off debt actually are paying out a lot less than the bonds one hopes to defease. Just to throw out a number, depending on the maturity of the bonds to be defeased the government bond rates that could be had right now cant be much more than 2-2.5% at most which is a lot lower than the rates of any of the city bonds out there.* The exact ratio could be worked out, but given the uber-low interest rates bonds are bearing today, it could possibly be up to a ratio of 2:1. Overly simplistically, but that would mean for every dollar in cash invested now, the city could only defease 50 cents of bond debt. That does not sound good.

All of this could have been dealt with just a couple months ago when the city called and refinanced around $50 million in debt. At that time, the refinancing could have incorporated this surplus cash and refloated debt could have been that much smaller if not zero. None of this debate would have even been necessary. This tells me the plan to shift cash into is a pretty new idea for what its worth. Again just my speculation, but I am guessing there is some idea that they may want to do this normally, but just don't want to do it anytime soon in this uber-low bond rate environment where for reasons explained above it would defease a low level of debt. If they wait out this period they may get more for it, but then the risk comes that the city will find other uses for that money. So this is all a poker game of sorts between the ICA, the pension fund, and all the other competing needs of the city. Kind of like wanting to have your cake and eat it to on their part.

* I'm actually being generous. The current yield curve for government T Bills and bonds goes from 0-2.5% for maturities out to 10 years. For maturities out to 5 years the maxium yield is under 1.6%. At the low end, you can't really defease any debt these days.


Anonymous Anonymous said...

A couple of question to ask regarding this reserve fund:

Are there any bonds that can be taken out with this "surplus" next year? That would guarantee a 4-6% return on the investment.

Did they decide against contributing more to the pension fund and are counting on a state (or other) bailout of some sort?

Maybe they are waiting for a further drop in the markets or at least some stability before making their move.

Or, as Joe King suggested, maybe they are just trying hide it from him.

Saturday, December 13, 2008 12:18:00 PM  
Blogger Bram Reichbaum said...

Regarding your speculative explanation: if the holdup is that bond rates are too low to make defeasement worthwhile (feasable?), aren't we all expecting things to stay this bad for quite a little while, keeping rates this low well into the immediate future?

Saturday, December 13, 2008 1:57:00 PM  
Blogger C. Briem said...

I would have to check, but I don't think any city debt is callable right now.

'Hiding' may be the wrong verb, it's not like people don't know about the $$ being talked about... but his point is close enough. I would say they are trying to sequester that money in a way the financial markets are not allowing them to do explicitly.

predicting the national recession is beyond me... but I would say that if US bond rates stay as low as they are then.... well, I won't speculate. Macro folks still pondering the fact that short term t-bills went to effectively a negative interest rate on Friday I think. Just something a bit unthinkable.

Sunday, December 14, 2008 9:14:00 AM  
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