The Next Bankruptcy to Hit Your Portfolio

There’s an old saying that if you owe the bank $1 million, you have a problem. But if you owe the bank $100 million, then the bank has a problem.

That’s the situation we’re in today.

States around the country have racked up outrageous unpaid balances for their pensions. Few of them have any plan for digging out of the hole. Since they have no plan, they’re creating issues for everyone who might be called upon to help them make good on their obligations.

Even if you don’t live in one of these states, you might still have a problem. In effect, the states owe a lot of money, and all of us are the bank!

Some states, like Rhode Island, tried to deal with the issue. That state slashed benefits and jacked up contributions.

But in many states like Illinois, state pension benefits are constitutionally guaranteed, so benefits cannot be cut. This leaves taxpayers in the state to foot the bills as they come due, no matter what the cost. And in some cases, bondholders suffer as well.

That’s where you might have a problem.

In Illinois, the unfunded liability sits at $110 billion and is getting worse by the month. After years of mismanagement by the state, Illinois has about 48 cents of every dollar it needs to make good on its pension promises.

Across the country, smaller entities like cities, school systems, and counties are suffering from the same disease – official mismanagement.

The basic problem is that current politicians negotiate changes, while future politicians are left to clean up the mess when things blow up. These changes include benefit increases, fewer years of service needed to retire, and how much the entity will contribute each year to the pension.

Now, the politicians who created today’s problems in the 1990s and early 2000s aren’t around to answer for their sins.

Meanwhile, the workers who toiled for years with their pensions in mind want what is rightfully theirs.

This is all coming to a head in states like Illinois, and cities like Chicago. The money’s running out, and government officials refuse to raise taxes any higher on their constituents.

It’s about to get interesting, and not in a good way. As to what lies ahead, we have two prime examples. One has already played out, and the other is still unfolding.

Fool Me Once, Shame on Me

The city of Detroit’s bankruptcy was the largest municipal failing in U.S. history. It owed $18 billion that it could not pay. With falling tax rolls and declining population, Detroit begged, borrowed and stole for years to keep going. Eventually it reached the end of its rope.

Besides pensions, the city was also indebted to its bondholders. At the time, investors who bought bonds felt pretty secure. After all, they were backed by the full faith and credit of the City of Detroit. Later on, they realized their mistake.

The contract said that bondholders would be paid before anyone else. No one ever assumes the worst – like a bankruptcy – will come. But here’s a question: what city officials in their right mind will choose to pay bondholders over their police officers, firemen and teachers? Even though it is legally correct, any politician that did so would be run out of town on a rail!

It’s true that some of those boldholders are regular guys like you and me just trying to fund their own retirement. Even so, the town had no intention of paying them with every last dime available. Instead, they diverted money to payroll and city services. They kept their city running.

That might seem like a humane decision, but it defied the contract the city signed when it took the money from bond investors.

The worst offender is the Detroit pension system itself. Detroit borrowed money specifically to top off its ailing pension plan, but then fell behind anyway. When the city went bust, it claimed this bond issue was unauthorized, and therefore they didn’t owe the bond investors anything.

They wanted to have it both ways: get the money, and owe nothing.

And that’s what happened. The bondholders that funded the pension received about 15 cents on the dollar. Meanwhile, the retirees got almost everything they were owed.

Fool Me Twice…

Now Puerto Rico is doing the same dance. The island Commonwealth owes roughly $72 billion among several issuers, including their power authority, general obligation bonds, local development authority, and “moral obligation” bonds.

I put the last one in quotes because these bonds were anything but moral.

When the island reached its maximum borrowing capacity, it wanted to borrow more. So instead of issuing general obligation or some other traditional bond, it issued what are called “moral obligation” bonds. These bondholders couldn’t sue for payment. Government officials were only morally, not technically, obligated to pay them.

That didn’t last too long. Puerto Rico has already quit paying on these bonds. Now island officials are negotiating with the other bondholders on how big of a discount they will get, even as the officials illegally move money from one pot to another.

Since this is a Commonwealth and not a city or county, it doesn’t have access to federal bankruptcy law. The government of Puerto Rico is supposed to pay its debts, period. And it can. The island has enough assets that it could sell to meet its obligations. It can also cut benefits and reduce payrolls.

But it won’t. Instead, it will lay the problem at the feet of bondholders.

This is where you become the bank.

If you own a tax free bond fund, chances are you own Puerto Rico bonds, and your fund will take a hit.

Unfortunately, most bond fund buyers don’t look beyond the rating and the yield on the fund. These metrics won’t help. Investors need to do a much deeper dive on what they own to make sure they aren’t holding the bag when things blow up. This is one time when it doesn’t pay to be the bank.