Monday, September 19, 2011

The Cat, the Pension, Uncertainty and Audacity

There is an almost infinite amount of fodder provided by the city’s pension funding resolution. You could have a whole public finance course discussing nothing other than this one little episode. Granted it’s all fiction, but since everyone else is going along, why fight it? In fact, it may be a lot more fun to discuss the financial engineering of it all now that we are past the politics. Let’s assume that all this mattered and deconstruct what actually happened. We need to do a thought experiment.


So let’s start with a box. No cat in the box. The box is a financial transaction. The box contains the principals to the transaction and nothing else including Party A, which owes a large sum of money to Party B. Party A borrows a large sum of money and transfers it to Party B to pay off the debt. Now Party A owes regular payments to the lender.

If we had an omniscient observer to what was going on inside the box, the observer would conclude that Party A had increased its debt. It had borrowed money in exchange for a long period of future payments. Debt is debt is it not? Now there is nobody else in the box, so it just happens to be that Party B is the lender as well as payee. Sounds strange, but it has a clear analogy to lots of business transactions where someone owed an unsecured debt formalizes the debt with a contract for future payments to pay off the debt.

So first off… did the city’s debt in all of this go up? The omniscient observer would say yes. Yet the whole point of this exercise was to not have the city’s debt go up. Call it something else if you want, but the city just had its total formal debt outstanding jump by a large amount. Funny nobody wants to talk about it like that, but it is hard to escape that reality.

Then there is the cat which I said was not in there in the first place. Dead or not? City pension: Funded or not? The questions are not as different as you may think.


Now the painful truth. City has just taken on a large debt all toward funding the pension system. What has been created through sheer force of will, chutzpah, and financial alchemy is really no different from a Pension Obligation Bond. Really not much different from the pension bonds floated in the 1990’s to the tune of around $290 million only to have the markets and pension payments gradually erode the $$ put into the pension system. 


The analogies to the pension bond are multifaceted. Everyone happy that the pension system is now funded at 62%. Guess what? After the pension bonds of the late 1990’s were floated, the funding status of the pension system was a disturbingly identical 64% at the end of 1999. So we have been in exactly this place in financial space once before.  Both times everyone declared victory in 'solving' the pension crisis.  Was not a solution then, and likely is not a solution now. 


Now the nails get pulled across the chalk board. Did the city get a good deal on its loan this year? Can’t quite call it a bond since there is no known bond prospectus, de jure or even de facto, in existence. In the 1990s the pension bonds were for $292 million. At the interest rates of the time, it would have worked out to coupon payments of $18-19 million annually. So the payments specified here (13.4 mil. leading to 26.4 mil. annually or an average of ~$23 million if you work it out) are actually much larger than the payments incurred by the older pension bond.

Yet the calculated value of the payments today, $238 million or so, are strangely enough lower than the funds that the city received from the old pension bonds which was $292 million in cash. So despite the fact that interest rates are much lower today than in the late 1990’s, the city is paying out more and receiving less in comparison. This all an artifact of the difference between the interest rates back then, around 6.5%, vs. the 8% discount rate used to calculate the NPV value of the new debt. The current ‘loan’ was not made at any market interest rate (since there was no market involved.. market is outside the box), but effectively at a rate set by the discount rate used in the NPV calculation.

That cat is becoming a bit easier to understand in a relative sense at least. Basically the city has borrowed money at a fixed 8% interest rate. Bad. But at the same time the lender is getting a high return on its lending. Somebody is guaranteed an 8% annual return. Since borrower and lender are both in the box and the lender is pretty much the city pension system.. a high guaranteed return is good. So did the city win or lose in the whole deal?

Confused? You bet. But it does not matter, it is all paper. The box also had an event horizon that was defined by the accounting system of the city of Pittsburgh.Clearly a black hole in itself, but everything happens inside the box. There was no outside money involved, not any outside parties. We will call PERC the omniscient observer I guess, being outside the box and not party to any financial transaction involving currency, real or notional. All they were doing was observing, but as with the cat the observer can impact what goes on inside merely by observing. So everything we are talking about happened within the space made up of City of Pittsburgh entities and accounting. Nothing changed outside the box.

41 Comments:

Anonymous MH said...

I wouldn't call a large increase in revenue, assuming they can get it, "nothing." So far, I've not paid much extra, but somebody is. I would assume at some point, they will conclude that letting competitors under price you is pointless and raise the parking tax.

Monday, September 19, 2011 10:50:00 PM  
Anonymous BrianTH said...

It is a new liability for the City, but it isn't a new debt, because no one lent money to the City.

I think keeping that in mind makes this situation less confusing. Since there was no loan, no one bought the asset for $238 million. The asset was VALUED at $238 million by the pension fund for the purpose of determining their funding percentage, but what the pension fund is actually going to receive is not $238 million today, but the promised cash flows in the future (maybe).

Meanwhile, the City didn't borrow money at 8%, or at any rate, since it didn't borrow any money. One might argue that 8% was too high of a discount rate to use in VALUING the asset (one might also argue the opposite, in light of uncertainties regarding future parking revenues), but that only matters if that valuation is too low to accomplish the City's purposes. This year, at least, it was not too low--and I don't see any reason they have to use the same valuation in future years.

None of this is to deny this is a new liability for the City, and that is an important fact. But it just confuses things to talk about it as if it were debt, which it is not.

Tuesday, September 20, 2011 10:05:00 AM  
Anonymous MH said...

one might also argue the opposite, in light of uncertainties regarding future parking revenues

Given that the Authority is complaining that it can't make the first payment, I think there is a great deal more than 8% worth of uncertainty.

Tuesday, September 20, 2011 10:14:00 AM  
Blogger C. Briem said...

liability, debt; is, is

Tuesday, September 20, 2011 10:14:00 AM  
Blogger C. Briem said...

How about this question. Since someone here said that yes, the pension fund could 'sell' its revenue stream to a third party... then would the city's obligtion to pay be more akin to an actual debt?

If you are the city's accountant.. what would be different from your perspective? A quarterly coupon payment you are required to pay, or a required payment to the new 'owner'of the revenue stream.

Tuesday, September 20, 2011 10:27:00 AM  
Anonymous Anonymous said...

The answer to your question is another question-

After Murphy got the pension to 64% funded, how much money did he put into the fund the following year?

Tuesday, September 20, 2011 10:40:00 AM  
Anonymous BrianTH said...

Debt is a form of liability, but not all liabilities are a form of debt. Species, genus, and all that.

A transfer of the asset from the pension fund to a third party wouldn't make any difference in the analysis. That asset would still be a liability for the City--and that does matter! But it would still not be a debt, because it would still be the case that no one had lent any money to the City.

Seriously, I think trying to treat this liability as a debt just confuses things.

Tuesday, September 20, 2011 10:41:00 AM  
Blogger C. Briem said...

the answer to anonymous is that in subsequent years the city put in exactly what its actuaries told them to per the Act 205 report. Probably no more, but I bet no less.

Tuesday, September 20, 2011 10:49:00 AM  
Blogger C. Briem said...

on confusion. So the lawyer cares about this distinction.. the accountant paying the bills does not.

Of course there is a bigger issue here.. I've sometimes asked folks at the city whether the city uses a cash or accrual accounting and they can never give a clear answer depending on the specifics. If that is your universe, this question of debt or liability becomes even less meaningful.

I really do wonder how that transition to the county's accounting system is going.

Tuesday, September 20, 2011 10:53:00 AM  
Anonymous MH said...

I don't understand the debt/liability distinction either. I know nothing of accounting. Logically, the city owes the same money to the same people. The only difference is the city has now said which specific money will pay a given specific bit of debt. Money is fungible and therefore this whole thing is nonsense, except some new revenue did come and it is a new revenue source that is as close to a commuter tax as possible politically.

Tuesday, September 20, 2011 11:05:00 AM  
Anonymous BrianTH said...

MH,

A debt arises when:

(A) You are given something in the present; and

(B) In return you promise to give something back in the future.

In this case, (B) sorta happened, but (A) definitely did not happen--no one gave the City anything in exchange for its promise to direct certain revenues to the pension fund. That is why it is a liability, but not a debt.

Again, I think all this matters because it is an actual fact that (A) didn't happen, and we shouldn't be implying otherwise by describing this liability as a debt.

Tuesday, September 20, 2011 11:45:00 AM  
Anonymous MH said...

(A) City workers gave labor (except for a few with no show jobs, but lets set that aside)
(B) City workers were promised a pension by people who knew they could be out of office when the bill came due.

Tuesday, September 20, 2011 11:49:00 AM  
Blogger C. Briem said...

I bet that cat is laughing at me out there somewhere.

You know what this reminds me of? Since BrianTH is clearly interested in public finance wonkery he will know the history. Almost everyone refers to the 1976 Bankruptcy of New York City. Now did NYC actually go bankrupt? Bankruptcy is a specific legal action and no there was no NYC bankruptcy. But it did run out of cash, it did fail to make some bond payments. Some folks use the contrived term "technical bankruptcy" to refer to what happened in NYC.

So I like that semantics now that I remember it. So yes Brian, there likely is no debt per se. We don't really know how this was structured and there might be a legal document between the pension fund and the city that reads like a debt was created.. likely not though. But to the degree it really matters I argue it just does not. But maybe I will call it a 'technical debt' which is at least as fair as calling it a 'technical bankruptcy' in NYC.

Tuesday, September 20, 2011 11:50:00 AM  
Anonymous BrianTH said...

MH,

If you want to describe the money that the City owes to the pension fund as a "debt", that is a different issue. But again, it just confuses things to imply that this latest development was done in exchange for that labor--it was not, because that labor was already given, and the debt for that labor already existed.

And this matters to both accountants and lawyers. What both will tell you is that this new liability did not in fact cancel or replace any of that existing debt. That existing debt still exists in its entirety, and I would again suggest that is an important fact to keep in mind.

Generally, I would hope that everyone could agree that in substance, all the City has truly done is pledged certain revenues to the pension fund. It did NOT borrow money using those revenues as security, and that distinction has various important implications (including that as far as I can tell, the City remains on the hook for any revenue shortfalls).

Tuesday, September 20, 2011 12:09:00 PM  
Anonymous BrianTH said...

Chris,

Assuming no such document exists, I think I just explained one of the many important distinctions.

Suppose that the City had sold a revenue bond for $238 million then transferred that money to the pension fund. Suppose then there was a revenue shortfall. The pension fund would still get its $238 million, the City would still not have to pay any portion of the future value of that $238 million in some other way, and the bondholder would be out the difference between the revenues it expected to get and the actual revenues.

You can even imagine the pension fund serving that role without a third party--it could hypothetically have agreed to accept the revenue pledge and cancelled $238 million worth of funding requirements from the City (I don't know if that is legally possible, but it is conceivable). In that case, if there was a revenue shortfall the pension fund would be out the difference and the City would still have the full benefit of the $238 million cancellation.

But I don't see any evidence either of those things happened. Assuming not, if there is a revenue shortfall, it just means the City transfers less money through this mechanism to the pension fund, and the City now has to make up the difference.

That is why these things matter to lawyers, accountants, and so on. It actually matters who bears what risks, because those risks will sometimes materialize. In this case, everyone should care about who bears the risk of a revenue shortfall, and it appears it is the City (unless there is something in the additional documentation we don't know about).

Tuesday, September 20, 2011 12:16:00 PM  
Anonymous MH said...

That's what I don't get. How did the city ever not bear the risk of a revenue shortfall? How has the risk been shifted?

Tuesday, September 20, 2011 12:20:00 PM  
Anonymous BrianTH said...

MH,

It hasn't been shifted. That's my point. A revenue bond (or something like one directly with the pension fund) could have shifted that risk, but it appears what the City actually did was leave that risk with the City. That's one of the consequences of creating a new liability but getting nothing in return for it.

And isn't that worth being clear about?

Tuesday, September 20, 2011 12:24:00 PM  
Anonymous BrianTH said...

I should have said "nothing UP FRONT in return for it" (it is that missing UP FRONT part that could have shifted risk).

Tuesday, September 20, 2011 12:26:00 PM  
Blogger C. Briem said...

In all seriousness.... there is a specific point to all of this that is not such a big deal.

Suppose that the City had sold a revenue bond for $238 million then transferred that money to the pension fund. Suppose then there was a revenue shortfall. The pension fund would still get its $238 million

In itself that isnt the point. I want to say that suppose the pension fund sells its claim on future revenue to a third party. Then it also gets its money for sure.

But I will make the point you are getting at. This all really is a revenue bond in the end. The claim on a future specific revenue source, which is not a claim on the city's assets at all. In many cases, revenue bond debt is indeed NOT considered debt of the entity of the entity issuing such debt. Whether that is your point or not, the reasons revenue bond debt is often not condsidered debt on an entity's books are much for thesame arguments you are making.

So if that is your point, I may agree with you. Still a revenue bond debt is debt if you take a slightly more general use of the term.

Then there is the issue that some feel there really is a claim on general city revenues in a full faith and credit way. That would obviate the revenue bond separation of the risk.

maybe we can all agree on that last point. No risk has been shifted because nothing happened.

Tuesday, September 20, 2011 12:27:00 PM  
Anonymous MH said...

Then I don't understand how a revenue bond could have shifted the risk away from the city. It could have shifted risk away from the pension fund, if that's what you mean, but I don't see how that helps anybody.

Tuesday, September 20, 2011 12:27:00 PM  
Anonymous MH said...

My last comment was to Brian's and, I think, answered in the second before I posted it.

Tuesday, September 20, 2011 12:29:00 PM  
Blogger C. Briem said...

In greater seriousness.. The actuary balked at even considering this whole thing an 'asset'. In many ways I bet they considered the revenue stream just as BrianTH is generally arguing and not really a debt. It really all comes down to the same argument in a way.

So is all perverse. BrianTH is arguing as I bet the actuary was that this all wasnt a debt and thus not really real enough to be an asset. Actuary changed their minds only in the week prior to all this having to be reported. Then here I am essentially arguing for the revised position that it all was a real debt, and thus a real asset.

So I agree with you Brian.. not a debt.. also not an asset. But you (not you you) can't have your cake and eat it too. It's all the city's fault for creating such a confusing situation. Who says we are not creative aroundhere.

Tuesday, September 20, 2011 12:38:00 PM  
Anonymous MH said...

Very creative. There's a group dedicated to the idea that if a neighborhood gets to be 6% creative workers, it will bloom. So far, they have ignored accountants but that may be a mistake.

Tuesday, September 20, 2011 12:44:00 PM  
Blogger Bram Reichbaum said...

Way out of my depth here but a question just occurred. We've recently been making $50 or $60 million annual payments to the pension fund, in order to pay our immediate obligations and keep the fund's balance sheet out of a completely abject nosedive. Now we've just dedicated $13 million per year specifically out of the parking tax in a solemn vow to the state so as to satisfy Act 44 which was the goal of all this. Is there anything preventing us from deducting that $13M from the $50-$60M we have been habitually (at least, of our own free choosing) been paying, thereby increasing our annual pension contribution and burden on the city's operating budget EXACTLY ZERO, while still technically having fulfilled our promise?

Tuesday, September 20, 2011 12:48:00 PM  
Anonymous BrianTH said...

I think we are converging on a common understanding. To clear up a few remaining points:

(1) In a true revenue bond, the payments aren't secured by anything but the revenues in question. So if those revenues fall short, that is the bondholder's problem, and the issuer keeps its cash. So they are a straightforward vehicle for transferring revenue risk from the entity that sells the bond to the entity that buys the bond (note there are often a variety of covenants attached to keep the issuer from abusing this position).

(2) No such thing has happened yet in this case, at least as far as I know.

(3) I do think it is interesting to ask what would happen if the pension fund could and did market this asset to a third party. That might serve to convert it into something like a revenue bond, thereby finally transferring the revenue risk from the City through the pension fund to this third party. However, I don't think we can assume that if that happens, the pension fund will get $238 million for the asset, and so the price for such a hypothetical revenue bond remains unknown.

(4) All this is central to understanding what is going on--or rather, what is not going on. Unless the pension fund has agreed to something I am unaware of, so far the City really has not changed its overall financial situation--not even as much as an entity that sells a bond. It is basically a financial nullity in that sense, but apparently this nullity nonetheless achieved its purpose (preventing an acceleration of pension payments).

(5) But maybe the City has actually released some control to the pension fund, allowing it to decide whether to keep the revenues itself or convert them to cash, with the City having to accept whatever cash the pension fund gets. If true, that would be interesting.

Tuesday, September 20, 2011 12:50:00 PM  
Anonymous The Wiz said...

Debt vs liability

If you have a kid, you have a legal liability to clothe,feed, and shelter said kid. Thats a liability. If you apply for a home mortgage, the liability to raise your kid is not figured in your total debt calculations.
But if you borrow money to pay for his clothing, food, or shelter then it becomes a debt and is counted as part of your indebtedness.

Does it work the same way for the city and all this financial shenanigans?

Tuesday, September 20, 2011 12:50:00 PM  
Blogger C. Briem said...

It is a truism that accounting is far more art than science. Public accounting maybe a bit more so.

But for Bram's basic question. The entire point of this is that the asset belongs to the pension fund independent of its calculated and required minimum municipal obligation. So the answer to your question as asked is clearly no.. it can't displace the other transfer of $$ from city to pension fund.

Now there are always caveats and the big one here is that in just the last couple years there has been something of a voluntary 'overpayment' of the MMO. Will that voluntary overpayment continue in light of all of this. I speculate not, which would in fact be as you describe a displacement of $$ that nets out the real impact in the end.

Tuesday, September 20, 2011 12:54:00 PM  
Anonymous BrianTH said...

I know Chris is trying in good faith to reach a common understanding, but I feel compelled to note that something can be an asset without being someone else's debt. I would fully agree that if this is the pension fund's asset then it has to be the City's liability, but that just takes us back to the liability/debt discussion.

I also think Bram is asking a good question. If the City could use these payments to reduce its mandatory contributions to the pension fund, then I would be personally less inclined to agree it was an asset/liability at all. I'm glad the state bought it, but I suspect that means no such offset is possible--although who knows what the state would agree to in order to avoid taking over this mess?

Tuesday, September 20, 2011 12:56:00 PM  
Blogger C. Briem said...

To be clearer if that is remotely possible.. the city's MMO is calculated based on a presumption that the asset is owned outright by the pension fund. So the MMO is required in addition to the parking revenue stream in question.

Tuesday, September 20, 2011 12:56:00 PM  
Anonymous MH said...

Unless the pension fund has agreed to something I am unaware of, so far the City really has not changed its overall financial situation

Agreed. And that seems about right. The pension fund (that is the managers of the pension fund) had the least power here. If anything fell through, they were 100% out.

Tuesday, September 20, 2011 12:57:00 PM  
Anonymous BrianTH said...

The Wiz,

That's a good example, and there are many other examples of non-debt liabilities (in fact I believe that despite our conversation above, unfunded pension obligations are considered by accountants to be non-debt liabilities). And converting non-debt liabilities to debt can be a very significant financial event, and thus it is significant when you have not done that as well.

Tuesday, September 20, 2011 1:05:00 PM  
Anonymous BrianTH said...

Will the MMO be recalculated (presumably lowered) on the assumption is a legitimate asset?

That's not a simple offset, but it would be a neat trick nonetheless.

Tuesday, September 20, 2011 1:10:00 PM  
Anonymous MH said...

If there is a way to lower the MMO, I'm sure someone will find it. I don't understand how that is calculated. Can the pension fund still assume higher returns on investment than the state uses?

Tuesday, September 20, 2011 1:14:00 PM  
Blogger C. Briem said...

Yes, the MMO has already been recalculated with the assumption that a $$ transfer the value of the 'asset' was made into the pension fund.

Did that lower the required MMO.. for sure. But did the MMO go down from the previous calculation. I am pretty sure it went up, but I have not added it up yet. Why did the MMO not go down. For all the reasons the MMO has been ramping up in recent years.

Tuesday, September 20, 2011 1:17:00 PM  
Anonymous BrianTH said...

That's still a neat trick. Put a label on your future contributions, and voila, you get to use their NPV to recalculate your MMO.

Tuesday, September 20, 2011 2:43:00 PM  
Blogger C. Briem said...

That 'trick' is the entire point to the whole exercise.

Tuesday, September 20, 2011 4:26:00 PM  
Anonymous Anonymous said...

Every debt is an asset to someone else. Plain and simple commercial law. Any further debate on this issue pure lunacy.

Tuesday, September 20, 2011 8:05:00 PM  
Blogger C. Briem said...

I believe we are debating the converse are we not?

Tuesday, September 20, 2011 8:07:00 PM  
Anonymous BrianTH said...

Wasn't part of the point also avoiding having to use a different assumed ROR?

Or, as I would call it, buying some time for reform of the relevant state laws.

Wednesday, September 21, 2011 11:40:00 AM  
Blogger C. Briem said...

Nobody expects any change in state laws to impact any of this. Nothing in process. Nothing being talked about.

The goal was to get over the 50%threshold. period. and the determination of that was all ceded to locally contracted actuarial analysis which was going to use the 8%.

So yes, there was a long term impact that they wanted to avoid and part of that pain was the more realistic investment return assumption, but in terms of the machinatons of December it was a secondary impact.

Wednesday, September 21, 2011 12:21:00 PM  
Anonymous BrianTH said...

I'm a long-term thinker. And 30-40 years is a lot of term when it comes to politics.

Anyway, maybe I am misunderstanding something, but I see at least two different MMO-related reasons to want to get the revenue pledge credited as an asset. One is that it would reduce the MMO directly simply by increasing the funding level (at least that was what I understood from the above comments--I wasn't originally sure that was true).

The other is that by preventing a state takeover, it allowed them to continue to use a higher ROR when calculating the MMO.

The second of those two reasons required making it over the 50% threshold. But does the first? Hypothetically, for example, if the asset was credited but for less than expected such that the funding percentage fell short of 50% (say 49%), wouldn't the MMO go up less than if the asset wasn't credited at all?

In fact I thought there was a third scenario, briefly considered, in which they got over 50% but then voluntarily turned over the pension fund to the state, which allowed them to get the benefit of the additional funding but still use an elevated ROR.

Wednesday, September 21, 2011 4:06:00 PM  

Post a Comment

Links to this post:

Create a Link

<< Home