The Cat, the Pension, Uncertainty and Audacity
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.