Fiscal Literacy Should Be Required for Elected Officials

Fiscal Literacy Should Be Required for Elected Officials
A pedestrian walks past a sign for a Merrill Lynch office in downtown Seattle on Sept. 15, 2008. Ted S. Warren/AP Photo
John Moorlach
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Commentary

Having served in public office for a quarter century, I marvel at the fiscal illiteracy of many elected officials. Now that I have a little time to reflect, I’m amazed at how a flim-flam-type salesman can come in and offer an idea where the only real winner is the salesman.

Orange County and its cities have become internationally famous for playing the sucker when an attractive scam is offered and taken.

Thanks to Orange County Treasurer-Tax Collector Robert L. “Bob” Citron, 187 agencies in Orange County and around the state deposited taxpayer dollars into his Orange County Investment Pool (OCIP). Why? Because the OCIP was outperforming banks and money market funds in achieving high yields. Why? Because Citron was borrowing to invest (carry trade), and he loaded up on derivatives known as inverse floaters.
Everything was fine until it wasn’t. As long as interest rates stayed low at the short-end of the interest rate yield curve and high at the 5- to 10-year range, everything was wonderful. But when the Federal Reserve Board raised interest rates to slow down inflation, the short-end of the yield curve went higher than the five-year range and the cost to borrow exceeded the yields being earned by four-year bonds. Like a hedge fund, the OCIP imploded, losing some $1.7 billion, resulting in Orange County filing the largest municipal bankruptcy in United States history.
The broker, Michael Stamenson of Merrill Lynch, became very wealthy from his trades with Citron. So the lawsuit of COUNTY OF ORANGE, a political subdivision of the State of California, and JOHN M. W. MOORLACH, in his official capacity as Treasurer-Tax Collector of the County of Orange, Plaintiffs, v. MERRILL LYNCH & CO., INC. et al., Defendants, was filed. This and the related lawsuits would result in settlements of more than $800 million, the largest such recovery amount in United States history.
But the salesmen keep coming. Interest rate swaps are sold on the very same premise the OCIP used. Instead of paying total average market yields on a 25-year bond, a municipality would only have to pay the interest rate at the short-end of the yield curve. For instance, instead of paying 8 percent total interest cost, a swap could have the municipality paying 1 or 2 percent, until the short-end of the yield curve rises above the long end, which occurred in 2008. Watching the movie “The Big Short” will explain what I endured in 1994, as what happened to subprime mortgage lenders 14 years later is eerily similar.
Jefferson County, Alabama, would fall for this strategy. Thanks to the massive spike in short-term yields in 2008, the floating borrowing costs went into the double-digit range, and this county would default on more than $4 billion of sewer system restructuring bonds and file for Chapter 9 bankruptcy, moving Orange County into second place on this notorious list. Lawsuits would also follow, and the story is most intriguing.

While serving as the county treasurer, I assisted in disrupting a similar strategy proposed for the Orange County Transportation Corridor Agencies (TCA). Had they consummated the proposed refunding (refinancing) transaction, I’m positive TCA would have met a similar fate.

Speaking of bond salesmen, the next gimmick to arrive in Orange County was offering Capital Appreciation Bonds (CABs) to school districts. Some school board members saw these as a way to obtain the necessary financing for their voter-approved school bond ballot measures. But the overall costs to the districts are unconscionable, especially when funds are not set aside in reserves to meet the obligation.

At the conclusion of the Dot.Com stock market rally, public defined benefit pension funds found themselves fully funded at or above 100 percent. The smartest thing to do at that time was sell these stocks and recognize huge profits, taking the proceeds and purchasing bonds yielding 8 percent. These institutional investors would have met their funding requirements for years.

Instead, the salesmen said this was an opportunity to improve the benefits to the participants in the plans. A fifty percent increase seemed reasonable. In California, literally overnight, with the passage of SB 400 in 1999, the California Public Employees Retirement System (CalPERS) went from a fully funded status to two-thirds funded. Thanks to an uncooperative stock market, CalPERS was at 71 percent as recently as two years ago, 20 years after this most fiscally detrimental flim-flam maneuver was foisted.
A large unfunded actuarial unfunded liability (UAAL)? No problem. The investment returns will always produce 8 percent a year. They didn’t. So, slowly but surely, CalPERS and its counterparts have been reducing the assumed portfolio yield in its actuarial assumptions to 7 percent and lower.
But this requires the municipalities to pay a higher annual required contribution. The result? Many California cities have reduced their police and fire department staffing by 25 percent. Thanks to layoffs, the most recently hired police officers were released first. Yes, inappropriate financial decisions have reverberations, even impacting the rise in crime and the risk to your personal safety.

Still have a large UAAL? No worries. Salesmen say it’s wise to issue Pension Obligation Bonds (POB) to pay down this debt and lower the annual required contributions. And the interest rate on the borrowings is much lower than 7 percent. City council members are, once again, persuaded that this is a smart move. But all that is being done is transferring the amount owed to the pension system to bondholders. What if the $100 million POB is deposited into CalPERS, and it loses 20 percent on its investments? The city now has $80 million in assets, but $100 million of fixed debt. Oops.

Unfunded pension liabilities played a key factor in the city of Detroit filing for Chapter 9 bankruptcy nine years ago, now the largest in United State history, moving Orange County into third place.

You would think the fiscal insanity would stop. But it doesn’t. We have Orange County cities that have entered massive style drifts, by going into fiscal areas well beyond what government is supposed to do. Examples include purchasing workforce housing and becoming landlords of projects that will end up costing more for their budgets, with a remote chance of ever serving as a revenue source. Project labor agreements are being agreed to on the assumption that capital projects will come in on time and under budget, but they almost never do.
We’re even seeing cities enter the electricity business. Now we’re talking token and fiscally dangerous attempts to be politically correct about climate change. For some reason, a salesman has said that working as the middleman between a major utility and the consumer will result in the rates charged being lower. And the electricity provided will be totally from renewable sources, as if the sun never sets or the wind doesn’t die down after dusk. This “feel good” financial maneuver will collapse in due time.

For some of our local municipalities, it’s a sad slide down the slippery road of pursuing gimmicky noncore business enterprises. When the economy adjusts, and it always does, these schemes will meet a disappointing fate. Unfortunately, it will be the taxpayers who are left holding the bag. The question then may be: “Which flim-flam man do we sue?” But the bigger question will be: “Why were these decision-makers voted into office in the first place?”

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
John Moorlach
John Moorlach
Author
John Moorlach is the director of the California Policy Center's Center for Public Accountability. He has served as a California State Senator and Orange County Supervisor and Treasurer-Tax Collector. In 1994, he predicted the County's bankruptcy and participated in restoring and reforming the sixth most populated county in the nation.
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