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Yes, Alyson, We Do Live in a Financial House of Cards

There are similarities between the county 10 years ago and today

October 05, 2003|John M.W. Moorlach

By coincidence, Orange County filed for bankruptcy protection in 1994, shortly after borrowing money to keep its pension plan fully funded. Now there's talk of borrowing again, which led Alyson Michie of Newport Beach to ask: "When will American taxpayers realize they live in a house of cards?" ("Bond-Investment Plan Is Insane Economics," Sept. 21).

Alyson, I asked this same question nearly 10 years ago when former county Treasurer Robert Citron crafted Orange County's now-infamous investment strategy.

There are differences between then and now, but there also are troubling similarities. The county's retirement plan investment portfolio, which is needed to fund benefits promised to current and future retirees, was hurt by a down market in 1994. Now it's facing the same pressures again.

The county could ease this current short-term pressure on its budget by borrowing funds to keep the retirement fund whole. But the bills eventually must be paid.

This isn't an issue only in Orange County. Many cities and counties have used and are planning to use pension obligation bonds to fund their pension obligations. But there are two things that must happen to ensure that the gamble works.

To succeed, the government agency doing the borrowing must borrow at a rate that's lower than the plan's anticipated and actual earnings rates. The difference between the borrowing rate and what the money earns is known as arbitrage. But accomplishing both is going to be difficult in a volatile investment environment, and this bet could easily become another version of Citron's "casino" bonds, which also used borrowed money to generate investment funds.

During boom years, long-term pension obligation bond proceeds can benefit from high returns. But if (when?) the return rate falls, the government still must increase cash contributions to keep within retirement fund guidelines.

Who's to say what a good rate of return would be in this economic environment? We won't know how we fared until the principal is paid off many years down the line. Maybe someone should place a call to Citron's infamous psychic?

Interest rates were soaring in 1994, and the Dow Jones Industrial Average was low. This year's investment environment is reversed. Interest rates are at historic lows, and the Dow Jones is still relatively close to historic highs. Hoping to achieve high returns in the foreseeable future would be optimistic at best. And if the pension plan's anticipated earnings rate slips, the arbitrage and anticipated profits will be wiped out.

The Orange County Employees Retirement system promises pension benefits for the county and many local cities. Though the fund is one of the best-performing public defined benefit pension plans in the nation, it is underfunded by close to $1 billion.

The stock market is not fully to blame for the huge shortfall. Nearly 65% of the under funding was driven by increased employee benefits. And two-thirds of these increases are tied to decisions made by the 2001-02 Board of Supervisors, including a 50% retirement benefit increase for public safety employees.

When the county last issued Pension Obligation Bonds in late 1994, interest rates were rising and the county was hard-pressed to squeeze out a minimal savings from arbitrage. Unknown at the time was that Citron was scrambling unsuccessfully to find cash to pour into his troubled hedge fund. He lost that race, and the county filed for bankruptcy protection. Ironically, the gamble eventually paid off.

While the county was working itself out of bankruptcy protection, the nation entered one of its longest bull markets. Lower interest rates lifted the bond market and sent equities soaring, pumping funds into the county retirement plan. But those gains were, by law, stuck inside the plan and couldn't be used for other county expenses.

A clever arrangement was struck. The county asked for permission to use the 1994 proceeds over time to pay off a portion of future required contributions. This unique cash bonanza eased short-term pressures on the strapped budget. But it's a case of borrowing from Peter to pay Paul, because the county will burn through the remaining funds in three or four years. That will create a financial crisis for a future board of supervisors. The 1990s bull market also allowed the county to lower contribution rates to the plan, but those savings were spent, not stashed away. The result is the "perfect storm" that our prior CFO warned about. No wonder he retired.

These realities led the county's Public Financing Advisory Committee to table the Pension Obligation Bond for further study. Let's hope the study focuses on fixing our budget instead of papering over it.

The Pension Obligation Bond is an idea worthy of study. And maybe it should be looked at again when the investment market's wind is at our back.

But it's a bandage, given the financial realities facing Orange County. The current group of elected supervisors may be gone when the perfect storm hits -- and the next board will be left to clean up the damage. A decade ago, the Board of Supervisors used a major borrowing-to-invest scheme to solve short-term budget problems. The proposed Pension Obligation Bonds proposal appears eerily similar and sends shivers up my spine.

Alyson also observed that "our politicians care only about the short term." She could not have been more right. Alyson, when can you start working for the county? It has 8-month-old CEO and CFO vacancies. Take your pick.

John M.W. Moorlach is Orange County treasurer-tax collector.

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