Saturday, February 26, 2011

Illinois is Good at Debt

The Illinois pension bond auction to fund the State of Illinois' current pension systems contribution was moderately successful attracting a bid-to-cover of 1.65 from 128 bidders bidding $6.1 billion for $3.7 billion.  The 2014 bonds had a spread of 280 basis points above comparable Treasuries, while the 2019 bonds had a spread of 240 basis points over comparable Treasuries.  The high yield for the 2019 bonds was 5.877%.  This was 179 basis points more than Phillip Morris corporate debt.  Only twenty percent of bids were from foreign investors who should have seen this offering as an attractive high yield diversification from European debt.

This bond issuance had been delayed to let the market digest Governor Quinn's proposed budget. As we have previously written, Illinois has serious deficit, revenue, unfunded pensions, budgeting, and credibility problems.  During the week the bond spreads over Treasuries narrowed down from 300 basis points to market whisper spreads to finally settle five basis points each below what the State expected.  Given that Illinois' credit default swaps are higher than California,  the large spreads and high yields are to be expected, however, the State tries to portray the average yield of 5.56% as "good".

Unfortunately, this was a necessary restructuring of debt to make this fiscal year's pension contribution, although the SEC is investigating how the pension contributions were calculated and disclosed to investors.

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Tuesday, February 22, 2011

Michael Pettis on China's Growth

In Michael Pettis' private newsletter "China Financial Markets" published on February 21, from which I am only allowed to quote, he discussed corruption in China's high speed rail lines which he basically sees a typical fraudulent behavior manifested towards the top of a market.  

Contrary to those who cite him to legitimatize their opinions that China will collapse, it is his opinion that "...a financial collapse requires specific balance sheet structures in which inverted liabilities (i.e. the opposite of hedged) are combined with self-reinforcing mechanisms that exacerbate changes on both the up cycle and the down cycle.  I believe however that with Beijing’s control of the liquidation process, of interest rates, and of investor behavior, the Chinese financial system is organized in part to prevent financial crises. 

"But in so doing it is also organized to exacerbate underlying imbalances and ultimately to increase the cost of the adjustment.  This means that if we are nearing the end of the growth model’s life (in the next year or two if there is a strong consensus at the top, or in the next three to four years if there is a difficult leadership transition), the adjustment will not occur as a crisis but rather as a long and sharp slowdown in economic growth."

In January, the inflation rate came in at 4.9% versus the same period last year, which was lower than the market expected.  However, the CPI basket was revised at the same time, bringing down what would have been 5.1% to 4.9%, by lowering the weighting of food prices by 2.21% and increasing the weighting of the housing sector by 4.22%.  Pettis sees this as convenient timing but not sinister.  Even so, the month-to-month increase suggest just under 13% annual inflation.  He believes the central bank's fifth 50 basis points increase will help temporarily, but "... most Chinese growth is the result of overheated investment, and removing the sources of overheating without eliminating growth is going to prove impossible.  I have been making the same argument for at least two or three years, and so far we have seen how Beijing veers between stomping on the gas when the economy slows precipitously and stomping on the brakes when it then grows too quickly.  I don’t believe anything has changed."

Most interestingly, bank deposits were down in January for the first time since January 2002 and he quotes Credit Suisse as stating that it was corporate deposits that went backwards and not household deposits as would have been expected near the Chinese New Year, which would indicate it is not seasonal and may be of concern.  Pettis, on the continued tightness in the interbank market, said "So why did corporate deposits drop?  My guess is that large businesses may be finding it much more profitable to lend money to other businesses, especially those who don’t have easy access to bank credit, than to deposit cash in the bank at such negative real rates.  Both the Credit Suisse report and an email I got last month from a friend of mine at Bank of China suggests that there may be an increase in intercompany lending, and to me this would be a very plausible consequence of negative real deposit rates."

He sees the Japanese concept of zaiteku (raising capital for securities investment, real estate, etc.), which cause increased speculation rather than business operations to build in the late 1980's leading to a subsequent painful contraction, as taking hold in China.  "From the Japanese experience (and many others) it is clear that when SOEs and large businesses find it profitable to speculate on asset markets, intermediate loans, or otherwise earn financial profits, they usually do, in which case we need to worry about three things.  First, financial transactions – especially when they largely replicate risks that are being taken already within the financial system – increase systemic risk even as they disguise risk-taking.  A problem in the financial markets is reinforced by a drop in corporate profitability tied to financial speculation, which then reinforces the problems in the financial markets.

"Second, Chinese banks already do a bad enough job of assessing credit (why not, when most credit risk is socialized?), and it is hard for me to believe that we are going to see much better credit risk management from corporate treasurers, and even harder not to wonder if guanxi will play an important role in this whole process.  Third, the more lending occurs away from the purview of the PBoC and the CBRC, the less control and oversight monetary authorities will have over the financial system...

"On the one hand overinvestment, excess liquidity and credit expansion, off-balance sheet activities, and zaiteku are generating huge growth and, along with it, huge risks, while on the other the PBoC and the CBRC are doing what they can to monitor, manage, and limit risks in the banking system.  I wonder if they can pull it off."

With respect to the problem of hot money flowing into China, Pettis suspects foreign direct investment (FDI) may be including a lot of disguised hot money inflows.  He agrees with Deputy Finance Minister Zhu that the United States' QE2 does cause an explosion of liquidity growth in developing countries if those countries intervene in their currencies; if there is no intervention there is no liquidity growth.  The State Administration of Foreign Exchange (SAFE) report said hot money inflows have been negligible.  "It turns out, according to most interpretations of the SAFE report, that the speculators creating the hot-money inflows are not the much-vilified foreign hedge funds – surprise, surprise – but Chinese businessmen bringing money into the country in dribs and drabs."

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Sunday, February 20, 2011

Are Illinois Bonds Worth the Price?

In January of this year, the SEC announced it had started an investigation in September 2010 of claims made by the State of Illinois relative to the accounting of actuarial future savings from last year's two tier pension reform creating different retirement ages and new contribution rates and pensions for employee's hired after January 1, 2011.  We have previously commented on this accounting grey area in which all current employees, not just new hires, appear to be used to estimate future savings which are then considered a current contribution by the State reducing its actual monetary legally required annual contribution to the pension systems.

During the week of 2/21/2011, Illinois intends to sell $3.7 billion in general obligation bonds to fund the State of Illinois' annual contribution to the Illinois pension funds.  The official statement (prospectus) of the bond issuance clearly refers to the SEC investigation and the actuarial and accounting issues involved (page 53 of the document or Adobe page 84), including the divergence of what is allowed under Illinois law and what is prescribed in GASB 25 as amended.  The actuarial method used and the possible inclusion of all current employees in the calculation are not considered appropriate or proper by most actuaries, as detailed in a New York Times article, "The Illusion of Pension Savings"..  This Asset Smoothing Method, as used by Illinois, also does not keep the ending period open but closes it at 2045, which Illinois admits will fail if any legislatively mandated annual ramped (increasing yearly to 2045) pension system payments are not made.

This $3.7 billion general obligation bond issuance is to make this fiscal years annual payment, because the State of Illinois does not have the money to make its annual contributions.  Although the State has just passed a tax increase, there was no provision for restricted pension funding and it has not been in effect long enough to bring in new revenue.  Pension contributions by the State must be made from general revenue.  Credit default swaps for Illinois are still higher than California, but have been falling since the tax increase.  However, the market (New York Times: "Illinois Pension Bonds to Test Investors' Faith") appears prepared to require a higher yield than expected.

This $3.7 billion is part of a fiscal deficit of at least $15 billion for FY 2011.  Another part of the deficit is $8.75 billion owed Illinois vendors in unpaid bills for goods and services.  A bill presently before the Illinois Senate would authorize a bond issuance for $8.75 billion to pay vendors and is being pushed heavily by Governor Quinn.  The administration calls it debt restructuring, which is technically correct, but the opposition party calls it paying bill with a credit card.  Given that the tax increase has not had time to provide revenue to address the deficit, the choice is either let Illinois vendors/businesses go out of business and/or layoff employees or pay the vendors and Illinois businesses alive and healthier.  While Governor Quinn's administration has been exceedingly slow, for whatever reasons, to make transparent, documentable spending cuts to create efficiencies, it is well known that spending cuts cannot solve the deficit, because the people are unwilling to accept the loss of services or tax breaks they personally enjoy and expect.  To turn different groups of people against each other to deprive the other group of their services or tax breaks and paint groups of people as undesirable is divisive political manipulation which is inconsistent with a republican democracy and cannot be tolerated in a free society.

The $3.7 billion pension bonds will be snapped up, primarily by foreign investors seeking high yields and diversification from the high yields of European countries.  However, the State of Illinois cannot continue to fund pension annual contributions with debt.  There needs to be a restricted revenue source which cannot be diverted.  This needs to be the last time bonds are used to make annual pension contributions.

The $8.75 billion bond authorization to pay vendor bills is necessary to keep Illinois business and employees at work.  This should be a one time debt restructuring, but Illinois has a horrible record for not taking action on a bipartisan basis to fund the services and necessary economic safety nets the people demand and expect.

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