You don’t have to be a clerk on the returns desk to know that when people pay good money they expect top value. Yet in the wake of the U.S. Securities & Exchange Commission’s allegations that the State of New Jersey hid serious flaws in its financial health, the buyers who plunked down $26 billion thinking they were getting higher quality bonds are strangely mute. As one fund source, who buys public bonds, told me, “We will steer clear of any discussion of what’s happened in New Jersey.”
The SEC revelations, made public on August 18, put fixed income investors, comprised largely of individuals and mutual funds or money market funds, in a tight spot. The SEC could post the bonds’ unique identifiers, known as their CUSIP numbers, on its Web site so any interested party could easily check them against the contents of their fixed income portfolios. The CUSIP numbers would also allow investors to check the bonds’ ratings and see which agencies issued them. But the SEC tells me it isn’t doing that. So my source imagines investors “scouring their portfolios right now” to find out whether they’re holding the subject bonds issued between 2001 and 2007. Even if the CUSIP numbers don’t match, he muses, they’re probably considering bonds they’ve bought from other states with the same questions. Did they tell us the truth? But here’s the real ringer, investors can’t question the bonds’ values without possibly triggering a downgrade of their own portfolios.
Since the State’s financial position is at least $46 billion less than advertised, investor risk is higher than they thought, which might have prompted bond buyers to ask for more return — the risk-adjusted-rate-of-return — and/or a lower face value. And shouldn’t the bond rating agency on each of the 79 issues get a chance to review the new financial data and possibly drop their ratings? If so, that might adversely affect the balance of the portfolio or threaten collateralized credit positions the assets may be supporting? These are questions nobody wants to ask.
Since the SEC reports that 69 percent of outstanding municipal securities, as of 2009, were held by individuals either directly or through mutual or money market funds, and closed end funds, it’s safe to assume the losers on the state’s deal were largely Average Joes and Janes. Bond funds and investment advisors and financial planners managers may be obligated to review the bonds, since investment professionals are sworn to represent and protect these unsophisticated investors, who, in many cases, must rely on fund managers to speak for them. Did the managers pay too much for the bonds they bought for Joe? If so, what are they obligated to do now?
If investment managers are wrestling with how to advise their clients, they’re not saying. Pimco, the Newport Beach, California-based global authority on bonds, which manages assets and advises clients who include state, municipal, union and private sector pension and retirement plans, declined to give me a comment on the SEC case. The Council of Institutional Investors, in Washington, DC, has adopted a no comment position on the charges. Similarly, a spokesperson for Franklin Templeton Investments’ New Jersey Tax-Free Income Fund, told me they would probably not comment on an SEC matter.
Maybe they’re not as motivated to speak out as they might be if muni bond fund returns weren’t doing as well as they are, says James W. Hughes, dean of the Edward J. Bloustein School of Planning and Public Policy at Rutgers University. Could be. Templeton’s New Jersey Fund’s Class A shares earned a one year gain of 5.16 percent, 6.06 percent since inception, despite maximum sales charges.
And, Hughes pointed out to me that the $60 billion the State still has in its pension accounts is enough to cover it for ten years regardless whether the State collapsed. However, there are no reserve funds to cover health care costs, he reminded me. They are being paid out of operating income; and job cuts in the face of rising healthcare costs means the payments can’t be sustained. In view of things like these, Hughes told me, “If states were to default, we might see an avalanche.”
Since the two New Jersey funds that the SEC cited in its charges as being underfunded by at least $46 billion are meant to supply workers’ retirement money, you could expect the American Federation of State, City & Municipal Employees (AFSCME) to have a few concerns. Lisa Lindsley, Director of Capital Strategies for AFSCME, tells me, “I’ve been wondering about what happened to the underwriters of the bond issues and why they don’t have liability? They’re not named in the SEC’s findings.” Good point.
The 1.4 million member union with over 200,000 current retirees has been on top of the New Jersey situation since the Christine Todd Whitman administration, she tells me. Back in 94 - 96, Whitman cut the state income tax losing the coffers $14 billion, and cut the state sales tax, at a cost of $10 billion more.
“So we could see this coming,” says Lindsley. Which prompts the question if Lindsley could see it coming, why didn’t the rating agencies put this together? Her members have considered as a “flawed business model” the practice of the issuers paying the rating agencies and had hoped the Dodd Frank legislation would change that, “but it didn’t.” However, Lindsley can see light. “Rating agencies will be made to use the same score card on government ratings as they use on corporations,” she notes. “Those with low leverage should get the same ratings as similar corporations would get.”
Another watchdog who’s been tracking the California employee pension funds for more than a decade, James McRitchie, has similar views on disclosure. “Public pension funds need to live up to the high standards of transparency they demand from corporations,” McRitchie, publisher of CorpGov.com, a corporate governance focused Web site, tells me. “Far too often, it is do as I say, not as I do.”
Lindsley sees pressures being applied to change that climate, like that from the Federal Accounting Standards Board which is turning its regulations on state governments and raising the bar on transparency, as well as comments like those from Arthur Levitt. The former SEC chief told Bloomberg News on August 20th that the SEC’s lack of a fine or penalty on the state amounted to a slap on the wrist. As for New Jersey’s employees, retirees, taxpayers and bondholders, Lindsley tells me all is not as bleak as it seems. The State has other options for raising capital. Refusing to give tax breaks to companies who play off the New York vs New Jersey rivalry in order to keep them from leaving, eliminating tax loop holes and tax abatements and insisting on combined accounting, so one part of a business can’t pay rent to the other half, thereby avoiding tax on the rental income, and similar dodges would start to refill those coffers. “Retirement security,” she says, “is import to everyone in the labor movement not just public employees, but everyone.”
Maureen Nevin Duffy is a freelance financial journalist based in New Jersey.
