MOORLACH UPDATE — Memories — May 27, 2013

Allow me to wish you a solemn and refreshing Memorial Day. It is always important to honor the memories of those who made the ultimate sacrifice and to remember that our freedom is not free. This morning I had the pleasure of attending the 32nd Annual City of Buena Park Memorial Day Remembrance Service with my folks. My mother and father purchased their Buena Park home, which is located in the Second District, nearly fifty years ago. My parents and their first two of four children, me and my younger brother Edward, moved into the current borders of the Second District some fifty-three years ago. Spending the morning in Buena Park brought back many great memories.

Yesterday’s OC Register had a great article on the topic of Pension Obligation Bonds (POBs). A few tips as you read this technical topic. If the pension system is utilizing an investment rate assumption of 7.75 percent, then borrowing at an interest rate lower than 7.75 should theoretically be a good deal. The bond proceeds are deposited into the pension system, thus replacing one debt, the unfunded actuarial accrued liability, with another, the POBs. Because it is not considered a new debt, the municipality does not need to obtain voter approval. Since the time that I was the Treasurer, and now as Supervisor, I have opposed the utilization of POBs. The graph at the bottom of the article confirms that for almost every year that I’ve been in office, this has proven to be a sound financial position. The OC issued $320 million in POBs in 1994, but they have been paid off using a technique known as defeasance. A website known as “Investopedia” defines defeasance as: “The borrower sets aside cash to pay off the bonds, therefore the outstanding debt and cash offset each other on the balance sheet and don’t need to be recorded.” The article provides additional insight into the fiscal distress of the cities of Stockton and San Bernardino, showing how the issuance of POBs added to the exasperation and furthered the need to pursue Chapter 9 bankruptcy protection.

Speaking of memories, in the spring of 2006, along with my regular duties as Treasurer-Tax Collector, I was campaigning for Supervisor and constructing the first Pension Obligation Note (PON) for the County. If you remember from the 2011 LOOK BACKS, even The Wall Street Journal took note of this strategy (see MOORLACH UPDATE — Pension Efforts — January 28, 2011). The utilization of PONs over the subsequent years has now saved the taxpayers of the County some $62 million!

Gambling to feed a pension monster

POBs often leave plan sponsors worse off.


The lure of getting something for nothing has long been hypnotic – and sometimes crippling.

Governments are not immune to the fever. Hundreds have bought into the promise of borrowing money at a low interest rate, investing it so that it earns a higher interest rate, and then reaping the difference as a windfall.

Finance types call this "arbitrage," and hundreds of state and local governments nationwide are doing it to prop up their ailing pension systems, to the tune of some $60 billion. In California, state and local governments have issued at least $16 billion of that.

Sometimes it works. But often, it doesn’t, studies have found – as the bankrupt cities of Stockton and San Bernardino can tell you.

This is the story of the pension obligation bond – alluring, despite the clunky name – and how some have resisted, some have been ensnared, and some, like the County of Orange, have figured a brand-new way to play the game.

"(I)t appears that POBs have the potential to be useful tools in the hands of the right governments at the right time," says a sober report by The Center for Retirement Research at Boston College. "Issuing a POB may allow well-heeled governments to gamble on the spread between interest rate costs and asset returns or to avoid raising taxes during a recession. Unfortunately, most often POB issuers are fiscally stressed and in a poor position to shoulder the investment risk. As such, most POBs appear to be issued by the wrong governments at the wrong time."

Anyone who remembers Robert Citron and the $1.6 billion bankruptcy stemming from, yes, arbitrage, knows that Orange County is not particularly famous for playing the market wisely.

But this, officials said, is different. They’re not playing the market at all, but are still managing to save taxpayers tens of millions of dollars.

So. Is there any such thing as a free lunch?


"It’s the dumbest idea I ever heard," former Democratic New Jersey governor and Wall Street CEO Jon Corzine told Bloomberg in 2008 when asked about POBs. "It’s speculating the way I would have speculated in my bond position at Goldman Sachs."

Still, state and local governments across the country sold $980 million of the taxable securities in 2012 to finance public-worker retirement obligations, data compiled by Bloomberg show. That’s up from $670 million in 2011, spurred in part by interest rates hitting historic lows.

California and Illinois have been the biggest players.

"A disadvantage of POBs is that the transaction is fundamentally one of leverage, where proceeds of bonds are used to purchase assets in the hope that the assets will return at least the assumed actuarial interest rate," said a report commissioned by the Orange County Fire Authority when it was mulling its unfunded liabilities in 2011.

"This introduces two interrelated risks: ‘leverage risk,’ where the issuer may be taking on debt it cannot afford to repay; and ‘arbitrage risk’, where the issuer is gambling that the return on the investment assets will be greater than the interest cost on the POBs….

"(I)t is important to time the issuance during recessions when the equity markets are at low levels in order to create an opportunity for the bond proceeds to generate significant earnings as the market recovers. The problem is: How can one tell if markets are headed higher or lower at any given time?"


Indeed. The Center for Retirement Research at Boston College examined the performance of nearly 3,000 POBs totaling about $53 billion in 2010, and the results were startling.

"(M)ost POBs have been a net drain on government revenues," it concluded. "Only those bonds issued a very long time ago and those issued during dramatic stock market downturns have produced a positive return; all others are in the red.

"While the story is not yet over, since about 80 percent of the bonds issued since 1992 are still outstanding, some may end up being extremely costly for the governments that issued them. … POBs could well leave plan sponsors worse off than where they were before they issued the POB. As such, it seems clear that in many contexts governments should avoid these bonds."

The fiercest critics assert that, by issuing POBs, we are picking our children’s pockets, shifting cost and risk to future generations.

Thad Calabrese of Baruch College – CUNY School of Public Affairs crunched some numbers and concluded that POBs have transferred between $2.8 billion to $3.9 billion from future taxpayers to current ones. That represented about 7 percent to 9 percent of the total face value of all POBs issued as of Jan. 1, 2008.

"POBs are not costless solutions to government financial difficulties," he wrote in an analysis for the Society of Actuaries. "Instead, POBs bring additional cost and risk into government financial decision-making."

To wit: The city of Stockton issued $125.3 million of POBs in 2007, paying 5.8 percent interest to bondholders. The city then deposited that money into its pension account, planning to earn 7.75 percent and come out ahead.

But the universe did not cooperate: The global meltdown hit, investments lost about 25 percent of their value, and the city was in worse straits than ever. It had an even larger debt to the pension system, on top of its debt to the bondholders.

Now the city is in bankruptcy court, telling bondholders it wants to pay them only 17 cents on the dollar.

It’s a similar story in the city of San Bernardino, which issued $50.4 million of POBs in 2004, hoping to fill a hole in the pension system. The hole got bigger, not smaller. It, too, is in bankruptcy court.

And not far behind, perhaps, is the struggling city of Pacific Grove, which issued $19 million in 2006. "This step did not resolve the City’s long-term pension obligations; and the City now owes tens of millions of dollars more," says a resolution from the City Council, taking aim at the California Public Employees Retirement System and how it calculates the hole in public pension funds – which is what spurs agencies to issue POBs to begin with.

Not surprisingly, Moody’s – the credit rating service that helps determine how much agencies will pay in interest when they borrow money – recently downgraded the ratings on 27 California cities’ POBs and similar unsecured borrowings.

And the Government Finance Officers Association issued an advisory in 2005 urging agencies to "use caution" when considering POBs.

There are more than just the obvious risks, scholars say. Suddenly having enough POB money in the pension fund – even if it’s borrowed – "may create the political risk that unions and other interest groups will call for benefit increases, despite the fact that the underfunding still exists," OCFA’s report says.


All that said, some feel these bonds do have a place in municipal finance. "With yields this low, it’s a very attractive time to borrow," Bud Byrnes of RH Investment Corp., a muni trading company in Encino, told Bloomberg. "It’s a great time to put your books in order, to take care of unfunded obligations that you have."

The Center for Retirement Research at Boston College expects the attraction to remain, especially after the global financial crisis. POBs offer budget relief during periods of economic stress ("With declining revenues, officials may see POBs as the ‘least bad alternative’ among a variety of tough fiscal choices"), and the promise of arbitrage – i.e., of easy money – "can be a compelling proposition."

Still, many have resisted temptation.

In 2011, when the Orange County Fire Authority was staring down a daunting $400 million hole in its pension system, it decided not to go the POB route, even as pension costs were swallowing a stunning one-quarter of its budget.

"Ultimately, the long-term solvency of the Authority’s pension system depends upon systematic contributions and not on POB borrowing," its report concluded. "POBs may or may not lead to budgetary savings over time, as the Authority cannot control the future course of financial markets."

The financially fragile city of Placentia also flirted with POBs as well.

Back in July of 2008 – shortly before the financial meltdown — the city council voted unanimously to authorize the issuance of POBs as "the first in a series of actions proposed for fiscal recovery."

Luckily, perhaps, for Placentia, the city’s weak fiscal condition, and the prospect of a low credit rating on the POBs, made it think again. The bonds were never issued.

The County of Orange, meanwhile, issued $210 million of garden-variety POBs in 1994, shortly before it filed bankruptcy thanks to bad bets on interest rates. It refinanced $121.7 million in 1996, and $136.9 million in 1997.

Then it pretty much steered clear of POBs – until 2006, when it got a burst of inspiration.


Rather than betting the farm on an interest rate spread it hopes the market will deliver, as traditional POBs do, Orange County crafted a way to simply take advantage of pre-payment discounts offered by the retirement system itself, officials said.

Traditionally, agencies pay their pension bills as they come due, every two weeks. But the Orange County Employees Retirement System – and other big gorillas – offer a break of some 7.75 percent for paying the whole year’s worth of bills up front, six months before the new fiscal year begins.

Why not take advantage of that?

In 2006, 2007, 2011-13, the county decided to do just that. In January, for example, it issued about $297 million of short-term POBs to prepay a $321 million pension bill for next year — shaving some $23.5 million from its total. Since 2006, this has saved the county about $62 million, said public finance manager Suzanne Luster.

The county is paying less than one percent interest on those bonds – all of which mature within 18 months — and repaying the bondholders with the money it, and its employees, set aside for pensions every two weeks.

Board of Supervisors Chairman John Moorlach – the man who blew the whistle on Citron’s risky arbitrage – thinks it would be crazy to pass up such essentially risk-free savings. "What Orange County is doing is the opposite of what traditional pension obligation bonds are," said Moorlach, who calls the county’s issue pension obligation notes, not bonds. "It’s a nice little play."

Others are playing as well. The Orange County Fire Authority has been pre-paying its pension bills to get the discount for about seven years, saving some $10.5 million, said Division Chief Kris Concepcion.

The Orange County Transportation Authority has done so as well, saving the agency millions.

Neither, however, has issued POBs – short or long term – to make those payments.

Short-term POBs appear to be in the distinct minority. Data from the Municipal Securities Rulemaking Board for California shows just a handful of agencies issuing short-term POBs, including Carmel, Fairfield, Riverside, San Bruno and San Leandro, along with Orange County.

So there may be a free lunch after all – at least, until the retirement systems take away the early prepayment discount because too many agencies are taking advantage of it.

Contact the writer: tsforza


May 25


Peter Brennan of the Orange County Business Journal provided a headline that we haven’t seen here in the County for nearly seven years, with “The B-Word Now is Boom, Not Bankruptcy – County Government Spends, Hires More, Thanks to Economy.” Here are a few selected paragraphs, enough to make you wonder how, when the economy was just barely beginning to provide an assist, that three years later the Board of Supervisors could approve a 50 percent increase in pension benefits, retroactive to the date of hire, for its public safety employees.

The Orange County government, like a patient that underwent open-heart surgery and is now preparing to jog, is returning to good health. County officials tend to point to post-bankruptcy austerity measures for the improved outlook, but the biggest factor appears to be a booming economy, which has contributed to increased tax revenue.

But taxpayer advocates, as well as some officials, including Supervisor Silva and County Treasurer John Moorlach have questioned why the county doesn’t retire more of its debt earlier. “Everybody’s pushing big rocks,” Moorlach said, using a term that refers to expensive projects. “I’ll stick up for early bond retirement – that will pay dividends, long-term.”

Moorlach is reluctant to say the county has returned completely to health, noting that beginning in 2001 the county’s annual debt payment will increase by about $13 million a year, to $91 million. (The annual payment is due to drop to $60 million in 2012). “The county has a very tight budget and it will for a very long time. We’re not flush here.”

Peter Brennan also did a second piece in the Orange County Business Journal, titled “County’s Timing Was Oh So Bad.” The first reporter that contacted me in late November of 1994 was David Evans of Bloomberg. He and I did a radio interview where I stated that if the County would hold onto its portfolio for a year, interest rates should be back down and the investments could be sold at par. I was accurate in my prediction, unfortunately, because my not being immediately called in to assist, the significant leverage, and the impropriety of the Citron strategy, would not allow such a gutsy move to be implemented. With litigation against Merrill Lynch, how to explain the should of, could of, would of scenario? It’s too bad that Merrill Lynch didn’t force the sale or hedge the portfolio against interest rate risk for a year. Here are the applicable paragraphs that address a pivotal point in the history of the County and my life:

County Treasurer John Moorlach is widely known for warning, during his election challenge of Citron, that the pool was risky. But he also said he advised just days before the county declared bankruptcy, that the county should hold onto its investments until the following year.

“The bigger issue is why were we gambling? What professionals would take us to this point that we’ve been leveraged 2.6 times?” Moorlach said.

Moorlach noted that Merrill Lynch itself advised the county to liquidate its fund: “Merrill Lynch didn’t step up to the plate. Merrill Lynch said, ‘Sell.’”


Stuart Pfeifer of the LA Times addressed the topic of PIP (Performance Incentive Program) in “Disagreement Over OC Staff Bonuses Grows – In tight times, two on the Board of Supervisors want the widely granted pay raises reconsidered.” Like the changing of the seasons, another economic cycle was in effect and the County would find itself short of funds, again. The PIP base-building type strategy is about extinct now at the County. Here is the piece in full:

Two members of the Orange County Board of Supervisors want to reconsider a $15.5-million bonus program for county employees, a move that could further strain labor relations in the county.

Supervisors Chuck Smith and Chris Norby have placed the county’s bonus plan on the agenda for the board’s June 10 meeting. Although the supervisors have asked only that the program be discussed, Norby said he might favor eliminating it.

The move comes one week after the county grand jury criticized the Performance Incentive Program as a hidden pay increase for most of the county’s 18,000 workers. The program is designed to be based on performance, yet the grand jury reported that more than 95% of the county’s workers receive the 2% bonuses each year.

For higher-income employees, such as attorneys in the public defender’s or district attorney’s offices, the bonuses can be more than $2,000 a year.

Nick Berardino, assistant general manager of the Orange County Employees Assn., said the union, which represents 13,000 county workers, will not agree to eliminate the bonus plan, which is part of a contract that runs through June 2004.

"If the board voted to do away with this, they would be in total violation of the contract," Berardino said. "There is no question about that."

About 150 union members attended the Board of Supervisors meeting Tuesday to show their disapproval of the grand jury report. If the board votes to reconsider the bonus package, relationships could become strained, Berardino said.

"I find it to be very disappointing that the board, during the term of a contract that is in effect, would be talking about doing away with an employee benefit," Berardino said. "That is virtually unprecedented in the over 25 years I’ve been representing county employees."

In its report last week, the grand jury was critical of several recent benefit increases for unionized county workers, including the bonus program.

"It is not a true incentive plan, but rather an across the board 2% pay raise for almost all employees," the grand jury stated in its report.

Norby, who was not on the board when the program was approved in 1999, said the grand jury raised significant questions at a time the county is considering layoffs and service cuts to balance its budget.

"Employee pay should be based on performance," Norby said. "But it doesn’t look like that’s the case. It’s an entitlement."

Smith said he wants county staff to prepare a report that would help him better understand the cost and effectiveness of the bonus plan.

"I want to see if we’ve gotten anything out of the money that’s being spent by the county, especially in these times," Smith said. "If the thing appears it’s not working, I’ll do everything I can to make sure the county is not losing a lot of money on something that’s not working."

Orange County Treasurer-Tax Collector John M.W. Moorlach, who has criticized benefit increases, including a potentially lucrative pension for law enforcement officers, said the bonus program also concerns him.

"I think it needs to be reevaluated. These are tough times. A thorough analysis of whether it’s been effective would be worthwhile," Moorlach said.

Norby conceded that the county’s contract with its unionized workers might make it difficult to rescind the pay bonuses. But he said that if the county is stuck with the plan, he will support changes to ensure that the bonuses are based on performance. And the issue will probably come up next year, when the county negotiates new contracts with its work force.

Berardino said it’s an issue he doesn’t expect his workers to be willing to negotiate.

"Doing away with the PIP program will be unacceptable to OCEA. That’s not an acceptable alternative, something we have no interest in doing and would not agree to," he said.

Smith said, "Everything is negotiable."

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