Detroit, pensions and securities lending: cops, COPS and swaps

The city of Detroit does not need another financial setback.  With unemployment topping 17% and ever increasing short term borrowing, the city is under an immediate survival imperative to cut spending or face insolvency.  State revenue sharing is being cut in the recent budget.  Local taxes, including the casino wagering tax are falling. 

The good news is that the city’s pension funds are nearly full, largely due to proceeds from the pension obligation certificates of obligation (COPs) that the city sold in 2005 and 2006.  Unlike Providence, Rhode Island or Dover, Delaware whose public employee pensions are less than 40% funded, the Michigan state constitution requires that pensions be funded.  This includes current contributions and the filling up unfunded liabilities through annual payments over thirty years. 

Full funding wasn’t always the case.  Despite the state law, the city’s two funds (police and fire and general retirement: PFRS and GRS) were significantly underfunded at the beginning of the decade.  The UAAL or unfunded actuarial accrued liability, approached $1.0 billion.   Trustees of the Police and Fire Retirement system sued the city in 2003 and 2004 to get them to fund the UAAL which led to the sale of the certificates.   In 2005 the city sold $536 million taxable pension certificates and then sold $936 million in 2006.  What seemed like a good idea at the time, the city also entered into two interest rate swap arrangements which the counterparties had the right to terminate on downgrade of the city’s rating below investment grade.  (The swaps are with UBS and Seibert, Brandford, backstopped by Merrill Lynch; FGIC and Syncora insure the certificates and swap agreements.)  When the city’s credit rating was downgraded this summer, they faced termination payments in the range of $300-400 million.  In exchange for not terminating the swaps, the city agreed to pledge first monies from its casino wagering tax to payment of the swaps.  New conditions that would trigger a termination were drafted including further ratings downgrades, a fall in the tax below 1.75X coverage or a bankruptcy filing.  The agreement is being celebrated as a “deal of the year” by the industry trade publication, the Bond Buyer – a bittersweet celebration given the city’s dire fiscal condition and loss of flexibility to use the wagering tax for other purposes.

Since the COP’s were issued two events could put the retirement systems out of kilter again.  First, retirees petitioned the city for an increase in benefits.  Older retirees felt that they were unfairly being paid less than more recent retirees.  In January, 2008 the city approved a change in the payment formula for older retirees.

Second, like most other investment plans, the pension systems had a significant loss of value in the last two years.  The police and fire retirement audit shows a $506 million decrease in net assets – and this includes about $1.0 billion assets whose value (approximately 25% of the system’s net assets) is determined by management without audit.  The GRS showed a drop in net assets of $429 million in FY2008, including about $1.0 billion valuation done by plan managers without audit (about 29% of net assets).  Add to this the fact that most pension systems assume 8% returns on invested funds an unlikely target.  Hopefully the recent market rally has filled the bucket a bit.

A recent actuarial study (as reported in the Detroit Free Press) showed that if the investment environment does not change, the police and fire pension contribution would have to increase to 50% of payroll (from 25% currently). The police and fire system audit included 8510 members receiving benefits and 4,179 active members.  The General Retirement system has 11,420 members receiving benefits and 9,361 active members.  There were also 2,000 terminated members not yet receiving benefits. 

The city is dependent on the retirement systems to be well managed or there are major budgetary consequences for the city.  The Detroit Free Press has run a series of stories covering excessive travel spending and some questionable alternative investments that the pension fund Trustees have made. 

While we are not equipped to comment on the quality of funds management we turn our attention to another practice that could introduce risk: securities lending.  Concerned about the risks that securities’ lending embeds in the financial system, the SEC held hearings at the end of September.    Losses on collateral and cash re-investment practices were key issues addressed.  Securities lending is a common practice of many large pension fund (and mutual fund) operations.  This large practice (estimates range from $2-3 trillion) grabbed attention when Lehman Brothers went belly-up and its collateral became nearly worthless.  Detroit’s pensions cited a total of $46 million in unsecured Lehman notes held as collateral in their funds.  How Detroit’s pension systems value this paper will not be disclosed until the next audit.  The losses are small relative to the size of the funds.  More troubling is the fact that the systems determine the market value of the whole securities lending program themselves without benefit of a review by the auditor. 

There is virtually no transparency or disclosure by pension funds about their collateral policies and reinvestment practices.  Basically a fund lends securities (U.S. government securities, corporate fixed income, corporate equities, etc) that are idle in exchange for collateral.  The collateral is supposed to be no less than 102% of the loan and good practice dictates daily marking to market.  This process is a way for broker-dealers to maintain liquidity and have the securities they need available for settlement.  In exchange, the funds make a bit of extra money on the securities they already own. 

The lender or its custodian or lending agent will typically re-invest the cash collateral.  While this is a common practice among fund portfolio managers and their agents, few municipal analysts look beyond a system’s UAAL.  Given the serious liquidity problems in short term markets over the last two years, a fund’s lending practices, collateral valuation and re-investment policies could introduce unexpected losses.  A municipality’s budget or taxpayers will ultimately have to make up the difference. 

In mid-October the Detroit City Council approved an additional short term lending for the city, maxing out its authority for the fiscal year.  The fiscal analyst’s office presented the following:

…What is troubling about this scenario is that if Council approves the TANs (tax anticipation notes) sale, the monies would be used essentially to pay off another short-term borrowing.  That is like opening up one credit card to pay off an existing one…In addition these TANs would be sold in November, which is to my knowledge since 2005, the earliest time short-term borrowing notes would be sold during the fiscal year….This would be fine if the notes were paid off in the same fiscal year….But in the City’s case, we are now looking to borrow short-term money earlier in the fiscal year that would be paid off from anticipated receipts during the next fiscal year

Further reading:

The International Securities Lending Association has some good “best practices” pieces on their website:

The Center for Retirement Research at Boston College recently published a survey of funding levels of major U.S. public pension systems

An excellent review of the consequences of our aging societies was done by the McKinsey Global Institute:

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One comment on “Detroit, pensions and securities lending: cops, COPS and swaps


Detroit will declare bankruptcy. It is only a matter of time. Who would buy their muni bonds?


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