No. of Recommendations: 8
Jaagu asks: Are you discussing all Calpers pensions and all CA muni bonds or are you discussing only those associated with Stockton/San Bernardino bankruptcies?

Jaagu, I cannot give you a precise answer for all California municipalities for one simple reason. There are literally more than 3,000 different issuers of California municipal bonds. I would not attempt to make any kind of blanket statement that treats all of them the same. There are a few areas that I think are actionable:

1) Calpers long-term pensions are at risk IMO. I would not worry about Calpers payments this year, next year or say the next 5 years. If you look 10 to 30 years out, I would be concerned. Let’s assume that Calpers investment returns the next 7 years are 1.0% nominal like Jeremy Grantham roughly forecasts. This will turn $1.00 into $1.07 by 2020. Using Calpers assumed return of 7.5%, $1.00 turns into $1.66. If Grantham is right, Calpers funding level will drop from ~ 75% down to ~ 48%.

In this scenario, we do NOT know how Calpers and the municipalities will respond. Extreme case number 1 is that they will assume all is well and good investment returns are just around the corner. They will NOT discuss dramatic premium increases and/or pension cuts. Extreme case number 2 is that municipalities will cry uncle and NOT pay the dramatically increased premiums. If they refuse, Calpers will be forced to reduce pensions with a broad brush. I don’t know if they would target the highest pensions first or do an equal percentage cut for all. It is unknowable at this point, but I would be nervous about all Calpers pension payouts say 10 years out.

2) Stockton/San Bernardino Calpers pensions are at risk much sooner IMO. The Stockton BK judge asked if “spiked” pensions could be rolled back. He is clearly thinking about it. Quite a few Stockton police/fire retired with pensions >= 100% of their final salary, typically at age 50. Stockton. “Spiking” where the last one year W2 was artificially increased was a common practice. It would not be surprising if these pensions got reduced in the BK process. This is what Calpers is fighting to death to prevent. The BK judge has wide latitude on how he deals with this issue. He might rule that Stockton can reduce their payments to Calpers. Then the legal issue is what Calpers will do to the Stockton pensions. The law is NOT clear on this issue, so it is up in the air.

3) If Stockton/San Bernardino Calpers payments are reduced via bankruptcy, I do think many more municipalities will use it as a negotiating tool with their unions. Either take reduced pensions starting tomorrow or we will declare BK. This is why the Stockton BK case is such an important precedence. There are quite a few other California municipalities in financial distress, so they would be tempted by the BK option.

4) From a municipal bond investment standpoint, this makes it a challenge to determine credit worthiness. Probably 95% of California muni bonds are good and will pay in full on time. The question is how to determine the 5% that are at risk. Stockton’s problems were well known and sophisticated investors were not surprised with their BK filing. San Bernardino on the other hand was a complete surprise. It came out of the blue and many professional investors were not expecting it. If the Stockton BK judge forces “cram-downs” where muni bond principal values are reduced, it will have a chilling effect. These are on both the General Obligation and “General Fund” securities. If municipalities find they can reduce their debt to bondholders by declaring BK, they will use this as a negotiating tool.

5) All of this is separate from California muni bonds that are in trouble due to other reasons. For example, look at COPIA: The American Center for Wine, Food and the Arts. [1] It was a large project backed by muni bonds that went BK. You see projects like this in all states, all of the time. The broader issue I am attempting to highlight is cities facing a tough choice between paying Calpers/pensioners versus bond holders. Traditionally this has not been a tradeoff, but increasingly will become pertinent IMO.

BOTTOM LINE IMO is that Calpers pensions’ long term are at risk IMO. Stockton/San Bernardino Calpers pensions are at risk short term. Some California muni bonds beyond Stockton/San Bernardino are at risk near term, it is just difficult to know which ones. The final chapter of the book will be complete when the Stockton BK case is 100% resolved, most likely at the US Supreme Court. In the meantime, we are left to speculate on the outcomes to pensioners and bond holders.



[1] COPIA: The American Center for Wine, Food and the Arts. Bankrupt entity backing muni bonds:
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