"The New Jersey Pension Scandal - A Canary in the Coal Mine for Munis?"

Sydney M. Williams

Thought of the Day

“The New Jersey Pension Scandal – A Canary in the Coal Mine for Munis?”

August 23, 2010

Should a fiduciary deliberately falsify the value of the assets for which he or she is responsible, the act would land them in jail, or at least subject them to a heavy fine. And that’s the way it should be. But, not so if you are a member of the legislature, the Treasurer or Governor of the State of New Jersey.

Last week the S.E.C. issued a cease-and-desist order against the State, its first securities fraud case ever against a state. New Jersey authorities settled the case without admitting or denying wrong doing. However, the S.E.C.’s findings against New Jersey would have landed individuals working in the private sector in jail.

The root of the problem, disclosed in the release last week in a cease-and-desist order from the S.E.C. against the State of New Jersey, is laid out in the “Summary”, paragraph 17. “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 (Teachers’ Pension and Annuity Fund) and PERS (Public Employees Retirement System) by 9.09%. In order to fund the enhanced benefits, without increased costs to the State or taxpayers, the legislation revalued their TPAF and PERS assets to reflect their full value as of, June 30, 1999, near the height of the bull market. Bond offering documents did not disclose the retroactive mark-to-market revaluation of the pension assets under the 2001 legislation until March 2003, or the reason for the revaluation. More specifically, bond offering documents did not disclose that the State used the market value as of June 30, 1999 in order to make it appear that the State could afford the benefit improvements.” The difference, according to the S.E.C. filing, was $2.4 billion – not chump change in the world of fraud, even on Wall Street!

Pointing to the fact that at least fraud is bipartisan in New Jersey, Mary Williams Walsh (whose article entitled “N.J. Pension Fund Endangered by Diverted Billions” in the April 4, 2007 issue of the New York Times appears to have initiated, or hastened, the S.E.C. investigation) wrote last Wednesday in the same paper: “The misstatements began during the Republican administration of Donald T. DiFrancesco and continued under Democratic administrations, including those of James MeGreevey and Jon Corzine.” This cavalier attitude of protecting their own and the hell with the public explains a finding by Scott Rasmussen, as quoted by him in an interview in the weekend edition of the Wall Street Journal: “The major division in this country is no longer between parties but between political elites and the people.”

The amount of bonds sold by the State of New Jersey during the period covered, 2001-2007, amounted to $26 billion in 79 offerings. Since, in the settlement, New Jersey neither admitted nor denied wrongdoing, but simply said they wouldn’t do it again, one could perhaps excuse the comment from an official of the New Jersey state Treasurer’s office, as reported in Thursday’s Wall Street Journal. “No investors appeared to have been harmed. ‘New Jersey has never failed to pay a bond holder and never will’, said Andrew Pratt…The state ‘aims to have the best bond disclosure in the nation and will continue to strive to achieve that goal,’ he said.” And, up until early December 2008, an employee of Bernie Madoff’s could have said the same thing!

The take-away from this case is multifold. First, the municipal bond market, at about $3.0 trillion is roughly the size of the corporate bond market; however, the S.E.C. cannot require governments to disclose anything; they can only prosecute them after the fact. The enormous underfunding of the retirement and healthcare plans for unionized public employees (estimated at close to $3 trillion, according to a recent survey from Northwestern University), combined with the dire financial straits in which States find themselves in present a combustible combination. Second, New Jersey’s plight showcases the absurd actuarial assumptions, regarding expected returns, that are being made by all public (and most private) pension and retirement plans; most assumptions fall in the 7.5%-8.0% range. In a world in which the yield on the Thirty-Year Treasury is 3.7%, using estimated returns more than double the long term Treasury yield is akin to giving Mr. Madoff your money after he was convicted. Third, the case reflects the growing view of people that politicians are a class apart, that they are immune from liability and responsibility. And fourth, the suit is a manifestation of the power of public employees’ unions; their concern is solely to their members, to the politicians who assure their jobs and to a grab for power on the part of union bosses; costs to society be damned.

In Friday’s New York Times, an article on New Jersey’s crisis noted that Governor Chris Christie has signed legislation that will curb benefits for new employees, “but the effects of that will not be seen for many years.” In the same article, the Time’s quotes Dr. James Hughes of Rutgers, “We’ve dug ourselves such a deep hole over so many years that I don’t see a way out.” Nevertheless, at least Governor Christie is moving in the right direction. This is a problem that is not going away. As Steve Malanga writes in an op-ed in today’s Wall Street Journal, New York, California, Illinois and Rhode Island are in the same boat.

Despite the ominous conclusions one can draw from the S.E.C. suit against New Jersey, thus far municipal bond holders appear complacent. Will this sense of complaisance be warranted? I don’t know, but I’m skeptical. There is too much money, promised to a few, guaranteed by a select group of politicians, but ultimately the responsibility of all taxpayers.