Pension Funds as Guarantors
Another area of prospective expansion of state public finance activity rests on the possibility of greater use of state pension funds to secure various debt issued within particular states. One state has already had its pension fund rated, and there are other states considering the appropriate use of pension funds for this purpose.
To utilize state pension funds in this way - as guarantors of certain state agency and local debt - a number of public policy issues arise in the process. For example, is this approach an indirect way of "social investing" that many state pension funds have rejected over the years? Second, who is the ultimate beneficiary of the pension fund - that is, the pensioners themselves?
Also, has the quality of the fund been lessened by security guarantees of municipal debt obligations? Does the pension fund have the legal authority to pledge, either as a general obligation of the fund or otherwise, to repay debt, and does this pledge have status equal or superior to the obligations it holds for future beneficiaries?
One way in which some funds have countered criticism along these lines is to justify the activity as an investment, pure and simple. The pension fund increases its current and future income through guaranteed fees and, based upon actuarial analysis, should have little exposure to nonpayment. In effect, pension funds would take on the role of insurer and reap the benefits and risks of that line of business.
State pension funds that would limit their activity in this field can state that the obligations they insure within the state can be analyzed thoroughly by virtue of the knowledge that the state enjoys about local and state agency credits. Some state officials have said that this prospective line of business allows the pension funds to leverage current assets for increased return and better protects the fund's ability to provide total cash flow requirements to pensioners in the future.
At present, this activity has been rather modest. However, it is starting to be explored more thoroughly.
One approach that has limited total fund exposure is the allocation of certain earmarked securities that relate to the amount of debt that has been insured by the fund, as a collateralized account, an escrowed account, for this purpose.
In the right set of circumstances, this escrowing can eliminate concerns by all parties regarding the conflict in purposes that the insurance program would otherwise represent; furthermore, it could result in a higher rating depending upon the criteria applied to collateral that is separated into an escrow account for benefit of the insured bonds.
Some counsel have argued that the structure should be developed along the lines of a letter of credit, but it is my belief that this arrangement adds to the fund's vulnerability since the debt would normally become payable at the time the letter is drawn upon. It also makes the transaction much more complex since most general obligation debt cannot be accelerated, as with a letter of credit for full payment.
It would be my suggestion that the state pension funds that take part in this program do so with a page from the municipal bond insurers - simply agree to continue to pay debt service as it comes due. This commitment would not reduce the marketability of the insurance, and this approach would not increase the fund's financial, cash outflow exposure.
My comments on state pension funds as municipal and state agency debt guarantor have been focused on certain structural and financial exposure matters. I have not commented on the philosophical aspects of whether this is a good or bad business for the funds to adopt.
For a variety of reasons, it does not represent a business that all state pension funds could pursue; in fact, it is our understanding that some states are prohibited under constitutional and statutory restraints. Moreover, some state officials have already voiced their displeasure with the approach.
Is there a market for these guarantors? Probably, on a limited scale. Because of investment and exposure constraints, the amount of debt that can be securitized in this fashion, on an individual fund basis, will be modest; however, some funds will, more likely than not, be more aggressive than others and could potentially take a meaningful share of a local insurable market. It is my opinion that this issue will go the way of pension fund social investment - some will do it in a limited way, and a very large percentage of the funds will simply decide not to play.
I would like to take a moment to discuss taxable debt. Generally speaking, taxable debt, as a more visible public finance issue, evolved out of the Tax Reform Act of 1986, more especially, in the area we have come to call private-activity debt and the various restrictions placed upon the debt issuance of these securities.
Initially, Washington believed that a much larger portion of the tax-exempt market would go taxable, but for a large number of reasons, including institutional reluctance, the public finance market did not embrace taxable issuance. The estimates by most federal bodies overstated the presumed amount of state and local debt that would be sold on a taxable basis in the aftermath of the Tax Reform Act.
Most taxable transactions have derived from bond structures that were previously utilized for tax-exempt debt.
I would like to cite a few recent issues that illustrate the types of concerns or purposes for which taxable debt obligations have been sold in the recent past. However, before doing that, it is important to make appropriate distinctions between tax-exempt debt under federal statutes and securities sold that are exempt under state law and constitutions.
For example, while certain securities sold by state and local governments may be subject to federal taxation, the existence of tax exemption under state constitutions and statutes may still bring advantageous results for investors in these debt obligations and, in turn, governmental borrowers. It is often difficult to quantify the special and precise impact of state and local tax exemption; nonetheless, for states with measurable individual and corporate income taxes, it is possible to conclude that the basis point benefit of state tax exemption could be significant.
Because the municipal taxable bond market is rather modest at this point, the fundamental elements that impact on the pricing of municipal taxable securities will be less sure than those that affect deeper and more extensive markets. For this reason, it has been problematic to assign the quantifiable relationship between local and state tax structures and the basis point advantage that a municipal taxable security will enjoy.
Many market makers suggest that local and state tax consequences have virtually no economic effect on the pricing of many municipal debt obligations that are subject to federal taxation. Of course, similar to the special tax treatment given to commercial bank-eligible investments, we can assume that there is implicit economic value to state and local tax exemption, and I therefore would argue that state and local government bodies should be sensitive to the taxability issues that surround security legislation over which these bodies have authority.
Away from the local and state tax issue, there are a couple of examples of taxable municipal transactions I would like to discuss.
As you know, it is often difficult to logically differentiate between public and private purposes. For example, we recently completed a tax-exempt bond issue for a client, including the costs related to a series of golf courses. However, since the government wished to retain the flexibility to have the related golf clubhouse managed in the future by a private party, then it was necessary for that portion of the bond issue related to the cost of construction of the clubhouse to be financed on a taxable basis.
The logical separation between the purposes may be less obvious, but the economics are quite apparent. Because of the thinness of the taxable municipal market, the cost in additional interest expense for the taxable portion was greater than the differential between high-quality debt, sold on a tax-exempt basis, and its counterpart, a high-quality, taxable corporate security. In this way, the market for small-volume taxable municipals will prove to be an economic disincentive to many state and local borrowers that have reaped the benefits in the past of tax-exempt issuance.
Another adverse factor affecting the desire of state and local governments to sell taxable securities involves the lack of flexibility attendant to the issuance of tax-exempt securities for certain purposes. For example, private-activity bonds are prohibited from being advance refunded. Thus, if a governmental issuer wishes to defease a bond issue that cannot be advance refunded, then the borrower is not allowed to do so until the bonds become callable on a current basis.
If an airport wishes to purchase facilities owned by airlines, but envisions the possibility of selling the facilities later, possibly back to the airlines in a more favorable economic environment, could the airport choose to utilize the tax-exempt securities for this purpose? Possibly. Of course, the airport could always sell tax-exempt debt that would be immediately callable, but this approach would increase the interest expense on the bonds as investors would penalize the borrower for the flexibility to call the bonds immediately to exercise the right to sell the facilities back to the airlines.
In this context, the use of taxable debt becomes an option to be considered. While the absence of volume has kept liquidity for taxable municipal obligations below acceptable levels for many institutional investors, the continuous increase of taxable municipal issuance will reduce the adverse effects of this problem in the future. But in my opinion, this marketability difficulty will be resolved only over a lengthy period of time, certainly not in the immediate future. For most issuers of taxable municipal securities over the next few years, they can expect to pay a market premium, and this factor alone will retard the sale of taxable municipal securities.
Johnson is the chairman of Government Finance Associates Inc. in New York City.