Wednesday, January 26, 2011

Pensions Versus Bondholders: Who Will Win?

There is a war raging—and it is over your money. Who will get it? The only thing certain is it won’t be you.
“The problem with socialism is that eventually, you run out of other people’s money.” That is a sentiment spoken by Margaret Thatcher, and a reality America may be about to face. With a tsunami of state and city bankruptcies threatening, the money grabbing is taking off. A lot of people are going to get impoverished in the process. Will you be one of them?
On Thursday, the New York Times reported on the grave danger threatening state budgets. Incompetent and corrupt politicians made trillions of dollars’ worth of retirement promises to state workers—then failed to put away any of that money. Taxpayers are now left to fund the retirements of extravagant union wages at a time that the economy is struggling and the population is rapidly aging.
The chickens are coming home to roost—and the $3 trillion tab is threatening to bring the house down.
Making matters worse, that $3 trillion deficit doesn’t count other state debt. It doesn’t count all the stimulus money that has now run out. Nor does it consider the fact that most states can barely even balance current budgets, never mind fund deficient pension promises. The socialist model, the same one bankrupting much of Europe, is now hitting America.
Consider Illinois (and it is far from alone). Earlier this month the state announced a massive 66 percent increase in income taxes. As startling as that is, even more startling is the fact that it still won’t make much of a dent in the state’s budget issues. Illinois is currently $6 billion behind in paying its vendors. But even with this massive tax hike, the state’s unpaid bills will still double over the next couple of years. Total Illinois debt, including underfunded pensions, is a shocking $130 billion. That’s over $25,000 per household. Illinois’s desperation is growing. In an attempt to fix its pension liabilities the state has borrowed billions to invest in the stock market. It has become a high-stakes Ponzi scheme: borrowing from one group of investors to pay returns to another group of people—and putting taxpayers on the hook for it all if it comes crashing down.
But what if taxpayers refuse to indenture themselves, and their children, to pay for political largess and union greed?
Even before Illinois’s recent tax hike was passed, the governors of Indiana and Wisconsin were expressing glee over all the business that was sure to flee to neighboring states. One politician called the tax increase the “nuclear bomb of jobs bills” as the fallout would lead to less hiring and a job exodus. Voters are answering with their feet.
In 2009, Oregon passed a big tax increase on the rich (people making over $125,000 per year) to try to balance its budget and pay its union pensions. After a year, the tax has only brought in about half of what the state hoped it would. Perhaps not so mysteriously, the rolls of the “rich” are shrinking, no doubt due to a deteriorating economy, but also due to migration to avoid the tax.
The problem with tax increases is that, as Greece and Ireland have found out, it generally leads to a smaller real economy, which makes debt payments harder.
So, if higher taxes alone will not solve state budget problems, what will? This is the great struggle facing states today. The answer to this question has the potential to rock financial markets as well as pocketbooks.
State bankruptcy!
According to the New York Times, policymakers are quietly working behind the scenes to come up with a way to let states do the unthinkable. According to some advisers, bankruptcy may be the only way out from under crushing debts, including promises to pensions. Apparently, the Feds would like to avoid having to use tax money from states that have made painful cuts to bail out states that refuse to make them. Plus the Fed has even bigger budget issues of its own to deal with.
The truth is that many states (including California and New York) are so burdened with debt they may be forced take a page out of Venezuela’s playbook and stiff their creditors and/or their retirees. Either that or reduce services to those of a Third World country. But as Venezuela, Argentina, Turkey and other countries have found, bankruptcy is a path fraught with unintended consequences.
One reason states like California can borrow money at reasonable rates is that investors believe states have lots of leeway to increase taxes. Illinois, Oregon and other states show that the political and economic reality may be different.
The other reason states have been able to borrow money is that lenders have almost never lost money. Only once in the history of the United States has a state defaulted on its debts, and that was during the Great Depression. But history moves on.
If a state were to default today, especially before going through the extremes of cutting its pensions, a wholesale reevaluation of the U.S. debt market could take place.
Bondholders are used to being put first. If states chose pension obligations before bondholders, who knows how much damage could be done to debt markets. Interest rates would not only soar for the state defaulting, but rates would probably rise for all states—making their debt situations worse and causing even more defaults. Additionally, many pension plans have invested money in the bonds of other states. Not only would they lose the money from states that have defaulted, but the value of their bond assets would crash as general interest rates rose—again pushing them further into the red.
If the economic crisis of 2008 should have taught us one thing, it is that the financial system is dangerously susceptible to herd mentality. Stampedes are sudden. People get crushed.
It is a nightmare scenario. But the alternative is ugly too. Millions of people rely on state pensions to fund their retirement.
What would you do if you woke up tomorrow to find out that your state pension had been cut in half? Or that you had paid into a system for 15 years and now you will get nothing?
If analyst Meredith Whitney is right, Americans need to start thinking about it—now. The looming state and municipal debt crisis “has tentacles as wide as anything I’ve seen,” she warned in December. It is “certainly the largest threat to the U.S. economy.”
But even if you don’t work for the government, don’t think your 401K is safe. Even now, European nations are confiscating private pension plans to prop up state budgets—in essence forcing people to turn over their retirement money to the government for the benefit of the nation. If you don’t think that could ever happen here, that’s what the Hungarians and Irish thought last year. The French, Bulgarians and Polish are fighting similar proposals today.