Brown and Pennacchi: The Champaign Gamble
The following letter written by Professors Jeffrey Brown and George Pennacchi appeared in The News Gazette on Sunday, March 6, 2011 at the top of the Commentary section.
Will Champaign Gamble with Borrowed Money?
By Jeffrey R. Brown and George Pennacchi
The Champaign City Council is considering the use of pension obligation bonds to help address its budget deficit. Advocates genuinely appear to believe that borrowing will reduce the city’s deficit and thus reduce the need to cut services to balance the budget.
Unfortunately, issuing pension obligation bonds to “solve” budget deficits is nothing more than an accounting gimmick that produces paper gains while exposing taxpayers to substantial financial market risk.
Here is a highly simplified version of how a typical pension obligation bond works. Suppose that a city will need to make a $300,000 contribution to its pension fund in order to cover the new pension benefits that its employees will earn in the current year. But instead of making this payment, the city borrows $10 million for one year at a 5 percent interest rate, so that one year from now it will owe $10.5 million.
The city invests the $10 million in a portfolio of stocks and bonds through the pension fund. The city is permitted by government accounting standards to assume that the investment returns on this $10 million will be 8 percent per year, enough to pay off the $10.5 million that is owed a year from now plus generate $300,000 of “free money.” They can then credit this free money towards this year’s contribution rather than actually coming up with $300,000 of cash to contribute to the fund, thus freeing up money that can then be used to pay other city expenses. Indeed, the more the city borrows and the longer the loan, the more free money it can generate!
If you think that “free money” sounds too good to be true, you are correct. The entire scheme amounts to little more than using borrowed money to make a risky bet that the stock market will perform well enough to pay back the original loan plus interest plus make up for the missing $300,000 cash contribution. What happens if markets do not perform so well? Then the bill to the Champaign taxpayers goes up, not down. And because bear markets tend to coincide with a poor economy and high unemployment, a large bill is likely to be presented to taxpayers when they can least afford it.
This absurd situation arises because government accounting standards do not require the city to account for risk. The City is allowed to treat the “expected” return on the invested funds as if it were guaranteed.
Doing so takes the short-term pressure off of political leaders by allowing them to avoid making hard choices on taxes and spending.
In order to sell this financial alchemy to unsuspecting politicians and taxpayers, borrowing through pension obligation bonds is often referred to as “refinancing.” We view such claims as the moral equivalent of intellectual fraud.
The term “refinancing” suggests that the city would replace high interest rate debt with low interest rate debt, a step that would indeed create real economic value. But pension obligation bonds do something entirely different – they increase the city’s total debt and gamble with the proceeds.
A household analogy is useful here. Real refinancing occurs for a homeowner when, for example, you replace a $100,000 mortgage at an interest rate of 6% with a new loan at a 5% interest rate. The reduction in the interest rate frees up real money that you can use to increase your saving or your spending on other goods and services.
The household equivalent of a pension obligation bond is quite different. Rather than refinancing your existing mortgage, imagine that a shady financial adviser comes along and makes the following suggestion. “Let me show you how to cut your monthly mortgage payments by $250. Go to a bank and borrow $100,000 of new debt, say at 5 percent interest, on top of your existing mortgage. You will then invest this new money in the stock market and simply “assume” that you will earn an 8 percent return on this risky investment. This will allow you to pay off the new $100,000 loan plus generate a profit of $3,000 per year ($250 per month). You can then take the $250 monthly savings ($3,000 per year) and treat it as “free money” to spend as you wish!”
Anyone with an ounce of financial sense would immediately see the problem with this advice – there is no guarantee that the $100,000 you invest will be able to pay off the new $100,000 loan plus generate an additional $3,000 annual profit. If your investments do not do as well as you assume, you will find that you have just dug a very deep financial hole that will require that you make much more painful financial choices in the future.
As finance professors, our first piece of advice in this case would be to fire the shady financial advisor. Our second piece of advice would be to accept the reality that there is no free money, and that the only true path to financial security requires that you make responsible decisions to balance your checkbook now.
This scenario, while highly simplified, is a pretty good analogy to the plan before the Champaign City Council. Issuing pension obligation bonds would appear to create free money by assuming that risky pension investments funded by borrowed money will generate a rate of return in excess of the rate at which the funds are borrowed. The city would then use this accounting gimmick to avoid making politically difficult decisions about cutting city services. Meanwhile, the city’s obligation to its current and future pensioners will not have changed by a single penny.
Governor Blagojevich played these games at the state level by issuing $10 billion of these bonds last decade, a gamble that turned out poorly and that we, as Illinois taxpayers, will have to pay for in the years ahead. We urge Champaign City Council to avoid following in his footsteps. Instead, we hope that City Council will show political leadership, true fiscal discipline, and full transparency by avoiding the temptation to put future taxpayers at risk by gambling with borrowed money.
Jeffrey R. Brown and George Pennacchi are finance professors in the College of Business at the University of Illinois at Urbana-Champaign.