July 26, 2013 7:51 pm

Detroit default exposes lie of phantom returns

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City’s bankruptcy highlights problems with US pensions and social security, says John Dizard
A pedestrian walks by graffiti in downtown Detroit in a Dec. 12, 2008©AP

Detroit’s bankruptcy filing creates a short timeline for the US to deal with the ‘un-finance-ability’ of its defined benefits pension and social security system

Dramatic news events are often less important than they are made out to be. This is not true of the city of Detroit’s bankruptcy filing. That cr eates a relatively short timeline for the US to deal with the un-finance-ability of its defined benefits pension and social security system. Of particular interest for the readers of these pages, it will also force severe changes in the business model for professional investment managers.

It is almost always better to settle disputes rather than litigate them, both for the parties directly involved and for the general public. That is not the case for Detroit and its creditors. This set of disputes should, and almost certainly will, be decided in the Supreme Court of the US. The federal judicial system knows the economic, political, and constitutional significance of resolving Detroit’s Chapter 9 bankruptcy filing, and it will provide as fast a track to the Supreme Court as possible, within the bounds of the law and professionalism.

“Fast track” here means about four years. That sounds like a long time, but resolving the legal, financial and generational-equity issues here would take agonisingly longer if left to the workings of the electoral cycle. Think of it this way: what are the chances that the contestants in the next congressional or presidential elections would ask the voters to decide if pension and healthcare promises made by governments are super-priority debts? Because that is what “Detroit” is all about.

The pensioners and Detroit’s public sector unions will argue that the labour contracts, along with the pension and healthcare benefits, are middle-class rights guaranteed explicitly by the Michigan state constitution, and should not be subordinated to Wall Street and the rich, ie bondholders. However, the beneficial owners of most of the bonds are also middle class, and the authority over bankruptcies the US constitution gives the federal courts appears to trump those rights.

Let’s say that this turns out not to be the case, and the unions and pensioners win in the Supreme Court. Then all those unfunded pension liabilities at the municipal level will be understood by the credit markets to have claims equal to, or superior to, those of bondholders. You can forget about the market for muni bonds. New York City? Chicago? Toll road revenue or water rates-based bonds?

Bonds issued by the state governments, as distinct from the municipalities they constitutionally control, are not subject to federal bankruptcy courts. The states are sovereign. They might default, but the federal government is not responsible for their debts, and its courts can’t order payments to their creditors. Even so, a loss by the municipal pensioners would create tremendous political pressure on state governments to reduce their own unfunded pension liabilities, even if that requires changing state constitutions. Many, if not most, municipal and state government workers are organised by the same unions.

Also, the final decision in Detroit’s bankruptcy will come within the same electoral cycle as a necessary restructuring of the federal government’s own healthcare financing. While the federal social security system won’t be technically insolvent by then, the same demographic grind that made Detroit insolvent will be evident at the national level. The Supreme Court has already ruled that social security benefits, unlike Treasury bills and bonds, are not full faith and credit obligations of the federal government. Constitutional lawyers already know this; soon members of the public will as well.

Yes, they will be incandescently angry with both political parties for deceiving them. That anger will also, justifiably, extend to what we could call the portfolio management class. After all, portfolio managers, along with their associated consultants, theorists, and, I’m afraid to say, journalists, have, one way or another, been telling pensioners and prospective pensioners that it is possible for everyone to earn an above-average return on capital.

Detroit’s broken pension promises were based, in part, on an assumed 8 per cent return on investment, within the range accepted by most US state and municipal sponsors. That is likely to prove a multiple of what it should have been, even if the “risk-free” return on Treasuries were to return to a long-term norm. A 5 or 6 per cent rate of return assumption is aggressive enough. The added phantom returns compound the pension plans’ underfunding by justifying reduced employer contributions or higher benefits.

All the little modelling tricks, illiquidity premiums, and PowerPoint charts used by portfolio managers to lure plan sponsors will come back to haunt them for decades to come. At some level of consciousness, everyone in the business knows this is true. Look forward to explaining to the neighbours they can’t retire when they thought they could because you were complicit in the lie that you could beat the index.


Letters in response to this article:

The real moral hazard underlying Detroit bankruptcy / From Mr Hank Gehman

‘Let them eat bonds’ may not be a good idea / From Prof Jay Weiser

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