Tag: Girard Miller

Muni Bond Games and the IRS’ Lurking Arbitrage Vampires

Mary Pat Campbell

Link: https://www.governing.com/finance/muni-bond-games-and-the-irs-lurking-arbitrage-vampires

Excerpt:

For example, Oakland, Calif., cleverly figured out in 1985 that it could issue tax-exempt bonds to fund its underwater pension plan, the proceeds of which it in turn would invest in normal pension portfolio holdings like taxable stocks and corporate bonds with a higher long-term return. It was a strategy almost certain to make a profit over time, even with the ups and downs in the stock market, but it didn’t take long for the IRS to put an end to that ploy as an abuse of the tax exemption. Thereafter, the IRS ruled, such pension bonds must be taxable.

Likewise, the arbitrage police have played cops-and-robbers with clever public financiers who invest their cash during construction periods at interest rates higher than their tax-exempt cost of money. Using today’s interest rate levels, for example, a tax-exempt 20-year AAA-rated bond can be issued with coupons around three-and-a-half percent and the proceeds reinvested in Treasury bills and notes at 4 to 5 percent. In almost any year like this one, there’s a profit to be gleaned when borrowing tax-exempt and reinvesting at taxable rates.

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There is also a new controversy brewing in a niche sector of the muni bond market, in which issuers of taxable bonds are finding an opportunity to refinance at lower tax-exempt rates. Investors are suing them. It’s premature to guess how this issue will be resolved in the courts, but worth watching.

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As interest rates drift lower in tandem with hoped-for disinflation, muni bond professionals are starting to chat up the idea that soon we’ll see a wave of advance refundings, in which a municipality can refinance its debt at a lower interest rate. In corporate America, the finance team must usually wait until the issue’s maturity or call date before refinancing. In muni-land, however, there is a unique situation that is peculiar to the tax-exempt world: the opportunity to issue new bonds to replace the old ones at a lower interest rate before their scheduled call date — typically within 10 years after issuance — by setting up an escrow fund to pay off the original debt when it is callable.

It doesn’t take a math or market genius to figure out that this advance refunding strategy is susceptible to abuses. In theory and previously in practice, it could be repeated several times over the life of the original bonds: wash, rinse and repeat. So the IRS caught on to this and Congress put a limit — of one — on such deals. To accommodate this unique feature of the muni market, the Treasury Department even created a special class of its own securities, known as the State and Local Government Series (SLGS, or “slugs” in industry jargon), which bear interest rates equal to the new borrowing rate to preclude the arbitrage profit gambit.

The political challenge for municipal officials today is that underwriters and advisers are keen to promote these advance refundings as soon as they become feasible. Some will compete with each other to make the first pitch to win an engagement even if it’s not optimal longer term. The motto of some hucksters is “whoever gets to the decision-makers first, wins.” All they really want is the engagement fees; to them, a dollar earned today is worth more than a dollar tomorrow, so they get lathered up without necessarily showing their clients the potential to save even more if they wait a couple years for even lower rates. This year and next could be just such a time period, depending on when you think the next national recession will occur.

Mostly it will be the muni bonds sold in 2022 and early 2023, when interest rates were peaking (above 4 percent on AAA paper and maybe 5 percent for lower ratings), that the advance-refunding promoters will pitch. Just remember that the IRS rules now prohibit multiple advance refundings: It’s one bite of the apple, and there will be an opportunity cost for jumping the gun ahead of lower long-term interest rates in future years. Although short-term interest rates are expected to decline, it’s not so obvious that the longer end of the Treasury and muni bond yield curves will follow in this business cycle, at least until the next recession. Refundings are almost always timely in recessions, but can be premature in the middle of an interest rate cycle.

Author(s): Girard Miller

Publication Date: 13 Mar 2024

Publication Site: Governing

Public Pensions: Double-Check Those ‘Shadow Banker’ Investments

Mary Pat Campbell

Link:https://www.governing.com/finance/public-pensions-double-check-those-shadow-banker-investments

Excerpt:

For almost a decade leading up to 2021, bond yields were suppressed by low inflation and central bank stimulus. To make up for scanty interest rates on their bond investments, many public pension funds followed the lead of their consultants and shifted some of their portfolios into private credit funds. These “shadow bankers” have taken market share from traditional lenders, seeking higher interest rates by lending to non-prime borrowers.

Even during the pandemic, this strategy worked pretty well, but now skeptics are warning that a tipping point may be coming if double-digit borrowing costs trigger defaults. It’s time for pension trustees and staff to double-check what’s under the hood.

For the most part, the worst that many will find is some headline risk with private lending funds that underwrite the riskiest loans in this industry. Even for the weakest of those, however, the problem will not likely be as severe as the underwater mortgages that got sliced, diced and rolled up into worthless paper going into the global financial crisis of 2008. And until and unless the economy actually enters a full-blown recession, many of the underwater players will still have time to work out their positions.

The point here is not to sound a false alarm or besmirch the private credit industry. Rather, it’s highlighting what could eventually become soft spots in some pension portfolios in time to avoid doubling down into higher risks and to encourage pre-emptive staff work to demonstrate and document vigilant portfolio oversight.

Author(s):Girard Miller

Publication Date: 8 Aug 2023

Publication Site: Governing

Why Municipal Pensions Should Kick-Start an Innovation Fund

Mary Pat Campbell

Link:https://www.governing.com/finance/why-municipal-pensions-should-kick-start-an-innovation-fund?utm_campaign=Newsletter%20-%20GOV%20-%20Daily&utm_medium=email&_hsmi=266390798&_hsenc=p2ANqtz-9XCnmkpBsz7qeaom3Wd8LYY7HJUvGw_23wYI3K2k_OJd4ifQ6BmeoSGQSkdqdPtxzuK5YefHRPo_EMn8DeMV66jxxg-vECbMbX4zn0u7Ma9C6-9B4&utm_content=266390798&utm_source=hs_email

Excerpt:

Most of the media coverage of the collapse of Silicon Valley Bank was focused on the long lines of depositors who feared losing their money and the eventual bailout by the FDIC. The sequel to that story is that the failure of that bank and several others left a gaping void in the nation’s entrepreneurial economy — the place where new jobs spring out of the innovators’ alchemy of novel technologies, management skill and risk capital.

As a result, many early-stage growth companies in America are now stranded in a financing no man’s land between the highest-risk seed capital stage funded by individual angel investors and the multibillion-dollar private equity sector that still looks for eight- and nine-figure deals featuring companies already making sales on their way to a stock exchange listing. The startups’ cash cliff has been cited as the cause of a “mass extinction event” — a dead cylinder in the U.S. economy’s growth engine.

That’s where the idea of an “innovation fund” partnering with a dozen or so midsize local government pension funds could fill the void in this still-risky growth stage. Pension trustees could harvest lush investment returns on a nationally diversified portfolio with lower fees than the venture capital industry typically exploits. As a bonus, they could collectively fuel the engines of economic growth nationwide. Emergent businesses based in a state where a pension fund participates would have a fair shot at some of that capital if they could pass stringent due diligence reviews and fiduciary governance oversight by angel investment experts in their industries.

It’s a concept that originated years ago from the now-retired founder of one of the nation’s most prominent pension consulting firms. Today, the drawback on his original vision is that the larger public pension funds have outgrown the startup economy. As the chief investment officer of the California State Teachers’ Retirement System, the nation’s second-largest public pension fund, recently noted in a TV interview, they manage so many billions in each asset class, and with so many rules, requirements and restrictions, that it’s difficult for them to effectively put money into the venture capital marketplace. And even then, it’s got to be the chunkier, later-stage money earning a lower return than angel investors are seeking. Accordingly, my proposals here are a second-generation revision for which I alone am accountable.

What’s missing today is early-stage Series A and B funding. Putting money into promising firms raising $5 million to $20 million of fresh capital in these transition stages following their angel funding round would never move the dial on the Goliath pension portfolios’ investment returns. For their trustees and staffs, it’s just not worth the effort and headaches of monitoring hundreds of pubescent companies that are too young for them.

Author(s): Girard Miller

Publication Date: 11 July 2023

Publication Site: Governing

More and Better Uses Ahead for Governments’ Financial Data

Mary Pat Campbell

Link: https://www.governing.com/finance/more-and-better-uses-ahead-for-governments-financial-data

Excerpt:

In its lame duck session last month, Congress tucked a sleeper section into its 4,000-page omnibus spending bill. The controversial Financial Data Transparency Act (FDTA) swiftly came out of nowhere to become federal law over the vocal but powerless objections of the state and local government finance community. Its impact on thousands of cities, counties and school districts will be a buzzy topic at conferences all this year and beyond. Meanwhile, software companies will be staking claims in a digital land rush.

The central idea behind the FDTA is that public-sector organizations’ financial data should be readily available for online search and standardized downloading, using common file formats. Think of it as “an http protocol for financial data” that enables an investor, analyst, taxpayer watchdog, constituent or journalist to quickly retrieve key financial information and compare it with other numbers using common data fields. Presently, online users of state and local government financial data must rely primarily on text documents, often in PDF format, that don’t lend themselves to convenient data analysis and comparisons. Financial statements are typically published long after the fiscal year’s end, and the widespread online availability of current and timely data is still a faraway concept.

…..

So far, so good. But the devil is in the details. The first question is just what kind of information will be required in this new system, and when. Most would agree that a complete download of every byte of data now formatted in voluminous governmental financial reports and their notes is overwhelming, unnecessary and burdensome. Thus, a far more incremental and focused approach is a wiser path. For starters, it may be helpful to keep the initial data requirements skeletal and focus initially on a dozen or more vital fiscal data points that are most important to financial statement users. Then, after that foundation is laid, the public finance industry can build out. Of course, this will require that regulators buy into a sensible implementation plan.

The debate over information content requirements should focus first on “decision-useful information.” Having served briefly two decades ago as a voting member of the Governmental Accounting Standards Board (GASB), contributing my professional background as a chartered financial analyst, I can attest that almost every one of their meetings included a board member reminding others that required financial statement information should be decision-useful. A key question, of course, is “useful to whom?”

Author(s): Girard Miller

Publication Date: 17 Jan 2023

Publication Site: Governing

How Deceptive Lobbyists Are Exploiting the Goodwill of Public Employees

Mary Pat Campbell

Link: https://www.governing.com/finance/how-deceptive-lobbyists-are-exploiting-the-goodwill-of-public-employees

Excerpt:

If you followed the saga of the route to passage of the Inflation Reduction Act, you already know that a last-minute maneuver by Arizona Sen. Kyrsten Sinema torpedoed a provision in the Senate compromise bill that would have finally closed the so-called “carried interest loophole.” That’s where savvy real-estate financiers and managers of private partnerships such as hedge funds and private equity deals are able to cut their income taxes as much as 40 percent by masquerading their compensation as a capital gain that enjoys much lower income tax rates.

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Public pension funds, public employees and their associations need to put a stop to this, and they have both the moral high ground and the clout to do so. It’s high time for political and financial blowback. The PR firms orchestrating this nonsense will just keep it up until their profiteering clients get called out.

….

The reality is that if the fund managers had to pay standard tax rates on their income, it would have zero impact on pension systems’ returns. What are the managers going to do? Cook up fewer deals? Pull up stakes and move to a tax haven? Demand even higher fees on top of their already cushy income? They can huff and puff all they want, but pensioners would lose nothing if the loophole were plugged.

Author(s): Girard Miller

Publication Date: 13 Sept 2022

Publication Site: Governing

Public Pensions’ New Quandary: Coping With Geopolitical Turmoil

Mary Pat Campbell

Link: https://www.governing.com/finance/public-pensions-new-quandary-coping-with-geopolitical-turmoil

Excerpt:

Arguably, trustees and investment teams need a serious conversation with portfolio managers who are overweight in companies and countries that could foreseeably lose favor and stock exchange value. To ground that dialog, some form of risk analysis is required. One protocol could be as primitive as routinely identifying which major corporate equity and debt holdings in a system’s portfolio have cost and revenue exposure of more than 10 or 15 percent in such potentially at-risk regimes, and prodding managers to trim down those geopolitically vulnerable positions unless there is a clearly compelling undervaluation thesis. Another sensible approach would be to require underweighting of major companies relative to a benchmark index, based on their percentages of autocrat-nation revenues.

Ultimately at a fiduciary level, if a pension fund’s total worst-case exposure to all earnings and income derived from autocratic nations is an insignificant fraction of its total portfolio, the composite risk is probably not worth losing sleep over, on purely financial grounds. But politics could still enter the theater stage for pension boards that ignore this issue.

Pension consultants and risk advisers have a new role to play in this dialog. ESG investing is now under fire, so a healthy ESG+G discussion is especially timely. If nothing else, informed advisers can help investment teams and trustees identify where their portfolios might contain a blind-side risk that hasn’t received enough attention.

Author(s): Girard Miller

Publication Date: 10 May 2022

Publication Site: Governing

The Fed Is ‘Normalizing.’ Here’s What Public Financiers Need to Know.

Mary Pat Campbell

Link: https://www.governing.com/finance/the-fed-is-normalizing-heres-what-public-financiers-need-to-know

Graphic:

Excerpt:

Of the $8.3 trillion of liquid marketable securities in the Fed’s portfolio (see the chart below), 37 percent are overnight repos and Treasury securities maturing in one year or less, 26 percent are T-notes maturing in one to five years, and another 30 percent are mortgage-backed securities issued by Fannie Mae and Freddie Mac, which pay down principal and interest monthly. So all it takes to pull back the excessive monetary stimulus left over from the COVID-relief era is to let such holdings roll off in 2022-24 without replacing them with new purchases. Operationally, it’s really not rocket science — it’s just a matter of conviction and messaging. Unlike the rising stairstep expected in the Fed’s overnight rates, its bond portfolio runoff won’t make nightly news headlines; it’s like watching paint dry. In this regard, doing nothing is actually doing something quite constructive on the inflation front, despite the lack of fanfare.

What would be the impact on interest rates? Little doubt they must go higher, barring an exogenous shock like a global virus lockdown or a Ukraine-war flight-to-safety. The key question is really how much higher, and how fast. My best guess is that markets have recently discounted about one-third of the potential move higher in long-term rates.

Author(s): Girard Miller

Publication Date: 15 Feb 2022

Publication Site: Governing

Will the OPEB Ostriches Ever Run Out of Excuses?

Mary Pat Campbell

Link:https://www.governing.com/finance/will-the-opeb-ostriches-ever-run-out-of-excuses

Graphic:

Excerpt:

As one stalwart finance officer once told me, “Our pension funds basically sucked up all the new revenue we’d been hoping to set aside to properly fund OPEB.” Those and other priorities for spending each incremental revenue dollar continued to crowd out the opportunity to institute consistent actuarial funding for OPEB benefits; the path of least resistance for policymakers who lack foresight and a sense of fiscal responsibility has been to keep kicking the can.

So it is that between 2015 and 2019, the state and local sector had clearly sorted itself into three classes of employers: (1) those who had trimmed or modified their OPEB commitments and liabilities to sustainable levels, (2) those who had begun actuarial funding of an OPEB trust fund, and (3) those doing nothing and leaving the problem to their successors and future taxpayers.

Author(s): Girard Miller

Publication Date: 18 Jan 2022

Publication Site: Governing

Do We Really Need States to Be Bankers?

Mary Pat Campbell

Link:https://www.governing.com/finance/do-we-really-need-states-to-be-bankers

Excerpt:

In 1919, the state of North Dakota established its own bank as a public institution. It’s the only one of its kind in the nation, having operated successfully for a full century through the Great Depression and a dozen recessions. Nine other states tried to follow suit in the following decades, only to fail and close their banks’ doors. Founded to provide capital in a farm-centric economy that was underserved by large regional financial institutions that charged double-digit interest rates for ag loans, the Bank of North Dakota has served as an inspiration and touchstone to political populists, anti-bank politicians and easy-money advocates.

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Even beyond what we call the “global superabundance of capital,” however, what the advocates and professional literature overlook is the spectacular disruptive growth of “fintech” — financial technology — that is bringing capital to previously underserved communities and businesses. It turns out that the capital markets, big data, artificial intelligence and techno-wizardry are filling in many of the niches that supposedly cry out for public banks. But first, there are two other strategic public policy alternatives of note: “linked deposits” and using pension-fund capital for nonbank lending, or “shadow banking” as it’s termed by its critics.

As a young municipal finance officer, while moonlighting in grad econ classes in the late 1970s, I became enamored of the concept of linked deposits. The idea was that municipalities should invest in time deposits with banks that pledge to make local loans promoting economic development. I’ll never forget speaking on a panel at the state finance officers’ conference and watching the state’s most prominent public funds banker scowl and shake his head in disgust at what struck him as a pie-in-the-sky concept. At the time, that idea went nowhere.

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Meanwhile, with interest rates at record low levels, public pension funds have been searching everywhere for ways to get a better return on their fixed-income capital allocations. One of the vehicles that emerged in the past decade has been direct lending through professionally managed portfolios that provide loans to businesses at attractive interest rates.

Author(s): Girard Miller

Publication Date: 7 Dec 2021

Publication Site: Governing

How States Can Gird for the Coming Fights Over Taxing Digital Ads

Mary Pat Campbell

Link: https://www.governing.com/finance/How-States-Can-Gird-for-the-Coming-Fights-Over-Taxing-Digital-Ads.html

Excerpt:

Maryland’s Legislature recently overrode a gubernatorial veto and enacted a new tax on digital advertising — the first of its kind among the states. It was inevitable that somebody would break the ice. Last August, I explored the revenue implications for states and localities of a federal tax on interstate digital commerce. Globally, the COVID-19 pandemic has accelerated business migration to Internet platforms, making this the new frontier for tax policy.

Maryland legislators deserve credit for planting their semi-checkered state flag first, to stake their claim, but they are still far from the finish line. Anti-tax wonks point to a host of possible legal snags that could tie up the Maryland tax for some time. They complain that it’s unduly vague, imprecisely crafted, and invites double taxation. The social media goliaths are already protesting that it’s unconstitutional under the commerce clause, which gives Congress supreme authority to regulate interstate business. To salvage its tax, Maryland may find it necessary to make defensible amendments that can withstand judicial scrutiny. But rather than going it alone, the state could use some help from its peers eyeing digital ad taxes of their own.

States have been called the laboratories of democracy, and rightfully so. However, when it comes to national and international commercial activity that sweeps across state lines through complex multi-party transactions, let’s face it: Heterogeneity and administrative complexity are not desirable outcomes. Fifty separate labs tinkering with different tax formulas will drive companies nuts.

Author(s): Girard Miller

Publication Date: 13 April 2021

Publication Site: Governing

Can Fiscal Alchemy Bolster Public Pension Funds?

Mary Pat Campbell

Link: https://www.governing.com/finance/Can-Fiscal-Alchemy-Bolster-Public-Pension-Funds.html

Excerpt:

One way to put a quick sheen on pension funds’ balance sheets is to issue municipal bonds at a lower rate of interest than the pension fund is expected to earn. These “pension obligation bonds” (POBs) have a long and checkered history. The first one was sold tax-exempt by the city of Oakland, Calif., in 1985. It stirred up a hornet’s nest at the IRS, which quickly realized that the lower tax-exempt interest rate was subsidized by Uncle Sam in a no-brainer for the pension fund that in theory could just invest in taxable bonds to make a profit, even without risking money in stocks. Congress was prodded to prohibit the use of tax-exempt debt where there is a profit-seeking investment “nexus,” and thus was born a thick book of IRS “arbitrage” regulations. Consequently, POBs must now be taxable, with a higher interest cost.

When interest rates are low, as they are today, the underwriters and many financial consultants come out of the woodwork to pitch their POB deals. The lure is always the same: “Over 30 years, you will save money because history shows it’s almost a certainty that stocks will outperform low bond yields,” even if they are now taxable. I’ve written extensively on the foreseeable cyclical risks of selling POBs when the stock market is trading at record high levels: The underwriters and deal-peddlers will sneak away with their fees from the deal, and public officials will be left holding the bag whenever an economic recession or stock-market plunge drives the value of their pension funds’ “new” assets below the level of their outstanding POBs. The Government Finance Officers Association (GFOA) has long opposed POBs for this reason, among others. POBs make sense to me only when they are issued in recessionary bear markets.

Author(s): Girard Miller

Publication Date: 16 March 2021

Publication Site: Governing