How did Detroit’s pensions fail so badly?

Pension liabilities are at the center of the fiscal collapse that led to Detroit’s bankruptcy filing today. The scale of the disaster, and the precedent its resolution will likely set, call for a closer look at what went so badly wrong for the funds.

Rapid decline                                   

The scale of pension underfunding we see in Detroit doesn’t usually happen overnight – it’s usually the result of years of terrible short-term political decisions. One of the many shocking aspects of Detroit’s pensions mess is that it became an enormous problem very quickly.

According to a 2005 press release from Fitch, in 2002 the city’s two big pensions  – one for municipal employees and the other for police and fire employees – were funded at 91.6% and 103.2% of liabilities, respectively. The pensions’ portfolios suffered significant losses in the market crash around that time, and the city did nothing to make up the difference (they were not alone in this). By fiscal 2005, the funding ratios had collapsed to 77.6% and 79.7% of liabilities, for a total unfunded liability of $1.7 billion.

That’s when the infamous then-Mayor Kwame Kilpatrick decided to turn to Wall Street for help.

Dealing with Wall Street: Heads I win…

In 2005, the city joined many other municipalities by issuing municipal bonds to “fund” its pension obligations. While these bonds do no such thing – they simply kick today’s liabilities into the future –they have proven to be catnip to borrowers as well as to Wall Street, which earned significant underwriting fees.

Even the initial borrowing appears to have been botched by the city council. A 2005 memo to the council from the city’s fiscal analyst seems to give evidence of confusion over the scope of the bond proceeds, which at $1.44 billion left nearly 20% of the funding gap unaddressed (some council members appeared to think otherwise). Not content with this arrangement, which cost the city over $40 million in underwriting fees, the city inexplicably decided only one year later to refinance $948 million of the total, paying underwriters an additional $61.8 million for the privilege.

Worse still, the council made the fatal decision that has come back to haunt so many municipalities (and even a potential Fed Chairman). No doubt following Wall Street counsel, the city entered into a complex arrangement involving floating-rate debt and interest rate swaps for $800 million of the new debt. In an opaque Rube Goldberg arrangement that only a banker could love, the deal ostensibly reduced the city’s interest rate expenses.

In reality, the deal turned into one of the largest line items in the city’s liabilities. The swap contracts included standard language to the effect that enormous fees could be triggered by major credit events such as a credit downgrade. It’s hard to imagine the city’s dysfunctional council reading the offering document, though perhaps they did. Either way, when the city was downgraded, hundreds of millions in fees were levied by the investment banks. Those fees now total $343.6 million, according to the emergency manager’s report, which is the lion’s share of the nearly $500 million in bond fees the city has paid Wall Street in recent years.

Criminally poor governance

In addition to making the terrible financial decisions above, Detroit’s financial managers have indulged in a who’s who of the worst in pension governance practices in recent years, treating the city’s pension funds as a piggy bank for personal and political gain. Worse, the rot among senior administrators seems to be condoned by their peers (for more, see here). The center of a recent series of indictments (including those that brought down the former mayor Kilpatrick) appears to have been the senior counsel for both pension funds. This attorney kept his job at one of the funds even after the investigations broke. His replacement at the other fund – chosen by the board – was chosen in spite of the fact that he was likely one of the parties caught on tape paying bribes in the investigations.

Corruption and bribery weren’t the only governance failures. In 2012, the city simply forgot to make its legally mandated annual payment to fund its pension. When the missing payment was discovered by an external auditor, the city’s interim leaders appeared to engage in a round of finger pointing that led nowhere. “For whatever reason, it was an oversight,” said the city’s fiscal analyst. It’s not clear whether the payment was ever made.

Manufacturing outrage

The one party who hasn’t come in for blame from the media but – in my view – really should is emergency manager Kevyn Orr. Orr is clearly not to blame for the historical problems that got the pensions into their current mess. But he has been extremely aggressive in boxing the pensions and their members into a weakened negotiating position by attacking them from two angles.

The first has been by massively inflating the pensions’ reported liabilities. Pension liabilities are enormously important but imaginary numbers based on projections about a combination of factors. Perhaps the most important of these is the discount rate, which in turn is usually based on the bond market. Using a higher discount rate makes liabilities seem smaller, and vice versa. The power to define that rate confers the right to define a pension’s viability.

Orr has played a savvy game around Detroit’s discount rate. In his creditors’ report, he noted that the old discount rate yielded a funding gap of just under $700 million, while using “more realistic assumptions” would boost the liability nearly five-fold to $3.5 billion. By repeating that number in talking to the press, without ever revealing the methodology behind it, Orr has mainstreamed the notion that the pensions face a funding crisis that demands emergency tactics.*

Orr’s second tactic has been more subtle. Less than a week after releasing his report, Orr also launched  a very public investigation into corruption at the pension funds. It’s hard to see what this investigation will achieve that the regular legal process has not, but it’s also hard to miss the political implications for the already weakened pensions beyond making the very retirees who have been hurt by the city’s buffoonery even more vulnerable.

Conclusion: TBD

It’s far too early to have anything conclusive to say, other than the obvious – this is the leading edge of a series of decisions that will need to be made about prioritizing bond investors versus retirees. It is going to be a painful process.

* Orr may also have needed to boost the perceived liabilities to give himself more leverage over the funds. The rules that give him emergency control over the funds stipulate that their funding ratios have to be below 80%. The police & fire fund didn’t meet that criterion under the old discount rate; presumably it does under the new one (though again, we don’t have any numbers to know for sure).

7/19/13 – slight copy edit

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4 Responses to How did Detroit’s pensions fail so badly?

  1. Pingback: Notes on the Detroit Bankruptcy | The Third Coast Conspiracy

  2. Pingback: There’s No Formula for Fixing Detroit, and That’s a Good Thing | Joe Garde

  3. Pingback: Wall Street plunders Detroit while pensioners take blame « Systemic Disorder

  4. Pingback: Wall Street plunders Detroit while pensioners take blame » Cancel Detroit’s Debt To The Banks!

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