Nightmare on Main Street


This will be a recurring nightmare for Main Street. Something that should make even Freddie Krueger cling onto his mother. We’ve already had some previews from the 2008 financial collapse. Small scale maybe but the lessons are real and this time round the effects are likely to be far larger and quantum levels more painful.

I wrote last month that the State of California’s pension fund (CalPERS) has unfunded pension liabilities of $412bn, or 3x the annual tax collection for the entire state. Rewind to 2008. The municipality of Vallejo, California filed for bankruptcy. It wasn’t just the evil banksters that caused financial markets to collapse that made tax revenues shrivel. Sadly the city of Vallejo was living high off the hog. Bloated pensions and fat cat salaries for public servants ruled by stubborn unions created a scenario where it couldn’t bail water fast enough when the crash hit.

The police captain was paid over US$300,000 while his lieutenants were on c.US$250,000. The average fire fighter took home US$170,000. The police and firefighters pay and conditions sucked up three-quarters of the budget much more than the 55-60% of most municipalities. That $80mn budget suddenly faced a $17mn black hole.

The city was forced to fire 40% of its 260 police officers and told its residents to be judicious with calling 911. Crime rates unsurprisingly jumped above the state average.

Vallejo didn’t sort its pension obligations to CalPERS during its bankruptcy negotiations which ended up becoming its largest budget hole by a considerable margin. Even in 2011 when the city came out of bankruptcy the pension time bomb ticked away. Moreover the declaration of bankruptcy prevented access to bond financing making budget gap filling even more complicated.

Scroll to 2016, the anaemic (and slowing) economic growth around the world is putting stress on pension funds ability to payout retirees and fund future pensions. Pensions funds set “return targets” which actuaries set to ensure the fund stays solvent. However pension funds need to be diversified with a mixture of cash, bonds and equities. With equities reaching more outlandish valuations and bonds moving further into negative yield territory (capital appreciating at least) pension fund returns are undershooting. When pension funds undershoot then the unfunded liabilities keep growing. As more baby boomers retire the more outflows are required putting more pressure on the unfunded portions.

Vallejo was small fry but the risk of more cities declaring bankruptcy in coming years is something that isn’t even on investor, national government or central bank radar screens. We’re fed more of the same tripe that all is ok and they’re in control.

San Bernadino, California also filed for bankruptcy after GFC carrying $140mn in unfunded pension liabilities including $50mn in debt it had raised to fill the pension hole. Yes! It was borrowing money to plug a pension hole. Sort of like buying groceries on the credit card you can’t pay off.

San Jose spends 20% of its $1bn budget on healthcare and pensions given the generous offer following 30 years service in police or firefighting. They net 90% of final salary every year to see out their retirement. Those sweet deals are now being contested in court giving people the option of the same deal with much higher contributions or accept a higher retirement age with a lower payment.

Take Detroit, Michigan. It declared bankruptcy around this time three years ago. It’s pension and healthcare obligations total north of US$10bn or 4x its annual budget. Accumulated deficits are 7x larger than collections. Dr. Wayne Winegarden of George Mason University wrote that in 2011 half of those occupying the city’s 305,000 properties didn’t pay tax. Almost 80,000 were unoccupied meaning no revenue in the door. Over the three years post the GFC Detroit’s population plunged from 1.8mn to 700,000 putting even more pressure on the shrinking tax base.

What we are likely to experience is more city and potentially state bankruptcies this time round. With over-inflated assets which aren’t producing returns and cash rates effectively zero or negative in the US, EU and Japan portfolio diversification gets more complicated pushing real returns lower and unfunded liabilities higher. There is no easy out. Printing more money will not help fill the hole. Even if it managed to keep nominal payments broadly unchanged the buying power would be severely diminished. What we can say is serious problems are being stored up and likely to arrive at the least opportune moment where realities will have to be faced and the blame game taken to new levels. It is truly a frightening prospect that once again Main Street will be left to carry the can!

This will not end well.


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