How to Clean Up the Muni Bond Market
The municipal bond market, once a quiet corner of Wall Street, is slowly becoming a scene of scandal and regulatory inquest. The Securities and Exchange Commission recently accused New Jersey of giving fraudulent information about its finances to municipal bond investors. The SEC is investigating officials in Miami for similar problems. The rate of municipal bond defaults—roughly $3 billion per year—is triple the usual pace, and analysts say many more bonds are on the brink because of the weak economy and low tax collections.
Should investors worry about their municipal bond portfolios? In most cases, no. The vast majority of municipal bonds pay off on time. Major disasters have been rare and confined.
That record of relative calm is a key reason munis have been spared the kind of regulatory attention given to their corporate bond cousins. In our view, that special treatment serves investors in municipal bonds poorly, leaving them under-informed about some of the risks they are taking. In the end, the biggest losers will be municipal bond issuers themselves, imperiling their ability to borrow at low rates in the future.
At the core of the problem are questions about how governments manage pension funds, what investors know, and when they know it. The case against New Jersey revealed that the state has made unfunded pension fund promises to its employees, and compounded the problem by not being forthright with bond investors. (The state settled without admitting wrongdoing.) In this case, the contrast between the corporate and municipal markets could not be sharper.
Pensions typically keep up with benefit promises through a combination of worker contributions, employer contributions, and market returns. But those have slowed to a trickle as states have cut back on their own contributions, employees have contributed too little, and hoped-for investment gains have disappeared. Most pension funds operate with an assumption that they can return an annual 8 percent or better on their money. In the last decade, the Standard & Poor's 500-stock index has returned around zero.
Pensions suffer from the same demographic ills as Social Security. The workforce is aging, people are living longer, and they are often retiring earlier—so benefits are getting more expensive to sustain. These problems afflict corporate and public pensions equally. Because of pension fund rules, corporations are required to step up contributions when their pension funds fall behind. Perhaps more important, they have to disclose their underfunded pensions to their investors in regular public filings.
Public pensions play by different rules. Most are under no obligation to keep their public pensions fully funded. Legally, government officials can keep their pension liabilities either under wraps in delayed filings or cloaked in opaque documents investors are unlikely to see or understand. Many pensions proclaim themselves healthy by virtue of past investment performance that is unlikely to continue and that may have already been undermined by more recent market losses.
Only because of dogged investigations did taxpayers, workers, and investigators discover that New Jersey stopped making pension fund contributions. The state said that prior year gains were enough to cover future benefits.
Meanwhile, government officials and labor unions have reopened pension agreements every few years, often agreeing to improve them for workers, usually through cost-of-living increases above inflation and options to "purchase" years of service toward pension payouts.
These pension fund problems could become a headache for municipal bond investors eventually. After all, any long-term problem facing states, cities, and other governments will end up harming their ability to pay their regular debts.
How big is the problem? Some estimate that unfunded retirement liabilities have grown to anywhere from $1 trillion to $3 trillion. Current retirees will still have their benefits, but the security of future retirees is in doubt.
This is not a problem with an easy solution. If states turn to taxpayers to backfill their pension liabilities, the tab could be huge: In Colorado, with 5 million citizens, the likely cost is now over $5,000 for every man, woman, and child, or three times the annual state income tax bill for a family with $40,000 in income.
Shutting down the plans would make things worse. The incoming funds from current workers keep the system's cost from being shifted entirely to the shoulders of taxpayers. Forcing public workers into 401(k)s won't work, as those are often more underfunded than pensions.
Nor can states and localities cancel their past commitments. Courts have taken a dim view of such unilateral moves.
The solutions, alas, can't be put off, either. Everyone involved—government employees, employers, and taxpayers—will have to share the pain. Here are the five essential steps for reform:
1. Congress must force states and other public agencies to admit their pension problems in timely, audited, plain-English reports using standards similar to those used by corporate pensions.
2. The SEC has the power it needs to enforce securities laws—except when it comes to the municipal bond market. For this reason, Congress should repeal the 1975 Tower Amendment, which prevents the SEC from having the same regulatory authority over the muni bond market that it has over its corporate counterpart. Such a repeal would allow the SEC to require that municipal bond offering documents be similar to those in corporate offerings, that governments follow uniform accounting standards defined by an independent board, and that ratings agencies apply the same standards to government and corporate debt instruments.
3. Even within its limited existing authority, the SEC should be more aggressive. The New Jersey case, for example, was resolved with no fines and without disclosure of the names of those responsible.
4. Congress should require that public pension fund boards adopt the same governance principles as companies. This would include greater disclosure and a majority of independent board members who can fulfill their fiduciary responsibilities to the employees in the plans. While neither of us regards corporate pensions as a picture of health, at least retirees, regulators, and investors are regularly updated on their condition, and companies are routinely forced to fund future benefits as market conditions change. That comes out of a truly independent audit.
5. Finally, states and localities should be permitted to sweeten benefits only if they agree to fund them fully. That will keep politicians from making more promises they can't keep.
The key to these reforms is the leverage of the marketplace, where investors make cold-eyed calculations of their risks. They need to be able to figure out which bond issuers are most likely to default due to pension fund obligations—and charge them more to borrow further. While that will be a harsh penalty for some states and localities, it may be the only way to save this market from ruin.
The stakes are really that high. For decades, the municipal bond market has allowed governments to build needed public infrastructure projects and fund operations affordably. If investors discover that the market has instead become a way to paper over irresponsible promises, they will flee it. And no state, county, or local government will be spared the damage that follows.