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Michael Cembalest takes a unique look at US states, cities, and counties using his signature comprehensive debt ratio. While municipalities have time to address underfunded obligations, some face difficult trade-offs.

/ 09:06
Michael Cembalest

I wanted to share some thoughts with you this week on the work that we’ve done on general obligation bonds of municipal issuers; states, counties, and cities. And, the reason I wanted to talk about it now, is at a time of tight credit conditions, it’s a very good time to do some clean-up in portfolios. And for many of our clients, you might be aware, we’ve done a lot of work every couple of years in this series called The ARC and the Covenants, which takes a very close, detailed look at the obligations of municipal issuers. And specifically, given the improvement in some of the disclosure, we can now take a very close look at the combined unfunded pensions, unfunded retiree health care, interest, and defined contribution obligations of municipal entities, as a percentage of their revenues. 

And, we put this all together in a thing called the IPOD ratio. I plus P plus O plus D over R. And, so far, we haven’t heard from any copywrite infringement people.  And, it represents the total obligations of municipal entities including; unfunded pension and retiree health care obligations, as a percentage of revenue collections. And, the picture is a very heterogenous one when you look across cities, and counties, and states. It is by far- it is not a picture of overall distress, there are pockets of severe distress, and then there are large groups of municipal entities who are figuring out how to do- how to maintain public sector pensions just fine. Where the combination of investment returns, employer contributions, and employee contributions are enough to pay obligations. And, so, it’s definitely a mis-statement to say that there’s some kind of an endemic, inconsistency in the ability of the defined benefits system to exist in a public-sector context.

That said, there are some pockets of severe distress, as many of you may be aware of. And, at a time of tight credit conditions, is a great time to clean-up portfolios in some of these credits. And our team here can share some of the research with you, so that you can get a sense of who they are, and we’ve generally graded a lot of these credits red, orange, yellow, some numbers based on the severity of the challenge their facing. 

As an example-I don’t want to single anybody out, but let’s take a look at the city of Chicago. Just so that you can understand some of the numbers involved. In order for city of Chicago, based on our analysis, to be able to pay all their future obligations they can do one or all of the following.  Let’s talk about tax increases, cuts in non-pension spending, or increases in worker contributions. And those are the three options that municipalities have to try to address their pension issues. And in the case of the city of Chicago, they would have to increase taxes 25%-30% every year for the next 30-years. They’d have to leave that tax increase in there for 30 years. And, sole use of proceeds would be to remediate underfunded pensions, and retiree healthcare plans. And so, given that public sector workers are only 8% to 10% of the work force, it’s unclear if there’s enough support to have that kind of tax increase on everyone with the sole use of pension fund, and retiree health care remediation.

Another option would be to cut direct non-pension spending by 15% to 18%. Again, that cut would have to remain in place for 30-years, and with all of that spending re-directed towards pensions. Or a 400% to 450% annual increase in worker contributions. And so, the challenge is that none of those three numbers, and even if you divide it into three and use a third, a third, a third in terms of trying to find a solution, those all seem to be some very, very, very difficult, and challenging numbers. And then similarly, if you don’t do any of that and just rely on investment returns to solve the problem, Chicago would nee an 18% annualized return on assets for the next 30-years. And I don’t think anybody’s that good. 

So, that’s an example of the work that we’ve done. And some of the other cities: Dallas, Baton Rouge, Phoenix, Pittsburgh, Atlanta, Cleveland, share some similar characteristics. But the details do matter, and so we would suggest that you take a closer look at some of our reports to get a sense for where the pockets of distress are. 

Sometimes clients ask me, “Why are you paying so much attention to these pension issues? We’re bond-holders, and from a legal perspective, you know, bond-holders are not cross defaulted with pension plans.” And, so, on paper a bond-holder might say, “I don’t see what my connection is to whether or not a pensioner is payed or not.” That may be true on paper, but in reality, that’s not how it works. In the seven, or eight, or nine cases that have taken place so far, any time that pensions, or retiree health care obligations have been restructured bond-holders have actually taken larger losses as percentage of principal. 

So, the reason that we pay so much attention to this issue as managers of somewhere between $40 and $50 billion dollars of municipal bonds which represent the safe-harbor in a lot of client portfolios, is that pension and retiree health care issues have proven to have a very, very clear impact on bond-holders when they get re-structured. 

And, just to finish the thought here. I want to be clear about something. The public-sector workers that we’re talking about here, form a critical part of our civil society. These are people that rescue, and protect us when we’re in danger, they make our lives safer, and cleaner, and more efficient.  They educate our children. They enforce the rule of law.  They ensure access to clean air, and water, and food. And- and the legal, medical, environmental, and educational problems that you find in other countries are a reminder of what life would be like without all of these public-sector functions. And, they’ve earned the benefits they’ve accrued, and have every right to expect them to be paid.  And, I want to be clear about that. The reason that we are spending so much time on this issue, is that in many states, and cities, and counties, we’ve reached something of an impasse in how all those obligations are simultaneously going to be honored.

And so, I cant think of a better time to make sure, and purge portfolios at risk of your credits than a time like now when credit-spreads are so tight, that they give up for selling out of a distressed credit, is much smaller than it might be when we are either; deeper into the cycle, or into the next down-turn.

Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of J.P. Morgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy, for J.P. Morgan Asset Management, and is one of our most renowned and provocative speakers. For more information, please subscribe to the Eye on the Market, by contacting your J.P. Morgan representative. If you would like to hear more, please explore episodes on iTunes or on our website. 

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