Tuesday, August 31, 2010

S.E.C. settles with the State of New Jersey

Or, why muni-bonds don’t belong in an individual’s portfolio

The S.E.C.’S settlement with NJ is a very curious filing. This posting tries to include the relevant quotes, but the reader can see ORDER INSTITUTING CEASE-AND DESIST PROCEEDINGS PURSUANT TO SECTION 8A OF THE SECURITIES ACT OF 1933, MAKING FINDINGS, AND IMPOSING A CEASE-AND-DESIST ORDER for details.

The actual settlement concerns how NJ disclosed its pension accounting in its bond offerings. The bonds at issue are: “from August 2001 through April 2007, New Jersey issued over $26 billion in municipal bonds in approximately 79 offerings.” Most coverage stresses other aspects of the filing. The story has been covered in national media without much background and with the level of “tisk-tisk” and finger pointing each outlet judges appropriate, often directed at that media outlet’s favorite villain. However, this posting isn’t about the media. It is about the curious nature of the filing. So, what’s so curious about it?

Both the fact that it occurred and the content of the filing are weird to say the least. Let’s start with the curious aspects of the fact that the filing ever occurred.

First, it seems curious that the S.E.C. would think anyone is unaware of the fact that governments make promises without funding them. That is especially true of pension benefits. Are they unaware of the SS and Medicare debates?

Second, most filings involve something where someone contests the substance of the filing. In this case, everyone involved from the unions to the politicians were already on the case. The unions have filed suits against the state, the governor has made so much noise about it that his political opposition has been calling him a bully for bringing it up, and even legislators were on it.

Third, the lack of someone contesting the filing has something to do with who is the aggrieved party and who benefited from the fraud. What follows from that is curious to the point of weird. The aggrieved are supposedly the people who bought the bonds. Without honest, adequate information they MAY have paid too much. Well, who are municipal bond buyers? Clearly, it was people who need the tax-free return, generally the rich. So, the filing is on the behalf of the rich.

Fourth, contrast that with who were the beneficiaries of the fraud. Well, the residents of the state who could have lower taxes and more goodies from state benefited. One important goodie was an initial 9% increase in pension benefits made to seem feasible by the initial accounting change. But, after that initial increase, subsequent accounting changes facilitated additional pension benefits. Suing pensioners for having benefit that are too high seems weird.

So, following that logic, this is a filing on behalf of the rich against the tax payer, pensioners, and citizens of the state. Is that weird or what?

Fifth, the filing got coverage despite a lack of any reasonable way to give it an ideological/ philosophical spin. It’s one government agency filing a settlement with another. It could, and undoubtedly was intended to, enhance one agency’s, the S.E.C.’s, growth prospects. But, it will increase the borrowing cost of another government, the State of New Jersey, thus cramping one vehicle for their growth.

Sixth, it is equally hard to take any speculation about a political motive seriously. The issue raised spans multiple administrations and legislatures of both parties. It was filed by a Democratic S.E.C. against a Republican administration in NJ, but the Republican Governor clearly wasn’t involved in the fraud and had been making waves stressing the same issues. Could it have been a Republican plant? Not likely. It raises borrowing cost for a Republican administration and is nice “tough guy” posturing material for a Democratic administration.

Now let’s address the content of the filing. Remember it is about fraud.

First, are we to believe the S.E.C believes governments don’t lie? Since when has a politician’s lying been a fraud?

Second, every government’s accounting has a level of opacity that would land the heads of any private organization in jail. Is this the start of an S.E.C. crusade to clean up how governments do accounting? But, alas it isn’t the accounting, as such, that led to the settlement; it’s that it wasn’t adequately disclosed. In other words, governments can account however they want, but if it involves a security, then they just have to make their disclosures as convoluted as their books. Or, put simply, simple deception is OK for the masses, but step it up for Wall Street. Wall Street deserves sophisticated and convoluted deception.

Third, while we’re speaking of accounting, this quote from the filing “…the State’s use of the BEFs as part of a five-year ‘phase-in plan’ to begin making contributions to TPAF and PERS; and (4) the State’s alteration and eventual abandonment of the five-year phase-in plan…” sounds familiar. Oh, perhaps I’m confusing BEF with SS trust fund and TPAF and PERS with SS. Governments regularly take money out of the right pocket, put it in the left, and replace it in the right pocket with an IOU from left pocket. Then, after spending the money in the left pocket, they can still claim to be well-funded because of all the IOUs in the right pocket.

Fourth, and still sticking with accounting, the filing for the settlement includes a lengthy discussion of NJ’s pension accounting. It seems the S.E.C. objects to the way the State applied mark-to-market accounting. In particular, they seem to take exception to mark-to-market using a past market high. That seems reasonable except it ignores the fact that if the high wasn’t right, it means the market isn’t always right. That raises serious questions about any mark-to-market accounting. The S.E.C. insists that accepted accounting standards, which include mark-to-market, have to be used by most issuing organizations. There is a contradiction.

There are two logical ways around the contradiction. One is just to say mark-to-market is appropriate sometimes, but not for pensions. That seems reasonable, but it probably applies to most assets not just pension assets. The Hedged Economist has criticized mark-to-market in a variety of contexts. But, the S.E.C. has made mark-to-market, if not the law of the land, at least the law of Wall Street.

The other way to eliminate the contradiction is to continue to believe in mark-to-market, but fabricate some rational for why the market is right if some other period is used, but not for a market high. The S.E.C. seems to have fallen into the trap of believing mark-to-market is OK if current period market prices are used. That’s silly. It would imply that at least some of the mistakes the filing highlights would have been OK if they had been made at a different time. For example, the filing states “On June 29, 2001, the State legislature approved legislation (P.L. 2001, c. 133) that, effective November 1, 2001, increased retirement benefits for employees and retirees enrolled in TPAF and PERS by 9.09 percent. In order to fund the enhanced benefits, without increased costs to the State or taxpayers, the legislation revalued TPAF and PERS assets to reflect their full market value as of June 30, 1999, near the height of the bull market.” If the benefits had been increased in June 1999, mark-to-market could well have shown them to be reasonable. Yet, the filing identifies them as one of multiple sources of the funding shortfall.

Fifth, the filing has lots of sound and thunder, but all perched on a very weak straw if accounting is the issue. Accounting isn’t really the issue. The S.E.C. makes the argument that the fund balances aren’t adequate to meet projected expenses. Few people would argue, certainly not the governor or the pensioners’ unions. That the bond offering didn’t adequately provide information to assess that risk is another issue entirely. To assess that risk based on accounting provides far less reliable information than a realistic look at how politicians behave. Yet, not surprisingly the S.E.C. avoids that reality by blowing smoke about accounting.

Sixth, the filing points out that the 9% benefits increase has a lot to do with the current state of the pension fund balances. That’s very curious. It skates real close to saying the S.E.C. should have some say in the level of state and municipal pension benefits for any government that plans to issue debt.

Finally, there is a way around dictating pension levels. The S.E.C. could dictate funding (i.e., tax and/or expenditure levels). But wait, the State already does that.

So, you might ask: “why such a curious filing?” Well, it wasn’t opposed, it could be done without appearing partisan, and it wasn't going it raise ideological objections, yet it let the S.E.C. do something. It let the S.E.C. look like they were doing something without risking making enemies. That's one reason. Further, it was done by a new Municipal Securities and Public Pensions unit. That new unit needed a non-controversial starter case since the threat of an honest look at public pensions has got to be scary for those politicians who will fund the new unit. Finally, the S.E.C. is trying to undo the Tower Amendment which reduced the S.E.C.’s power. This settlement fits into their lobbying quite well. So, if you look to the S.E.C.’s quest for money and power, the filing makes sense. It has nothing to do with NJ or protecting muni-bond buyers. In the muni-market buyer beware is still the rule.

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