The Los Angeles Times reports today that states and cities are increasing their use of borrowing to finance pension fund shortfalls, even though the practice has been disastrous for most governments who have used it in the past. According to the Times, issues of pension obligation bonds, which even former Jersey Gov. Jon Corzine once called "the dumbest [investment] idea I ever heard" (so you can imagine how dumb they must be) has increased since 2009 from $1.4 billion to $5.2 billion last year. This despite the fact that many POBS are under water.
A 2010 study by the Center for State and Local Government Excellence summed up the damage. It looked at 
thousands of bonds states and cities had issued in order to put money into their pension funds, and then calculated the average returns in stock and bond markets over that time compared to the interest costs that localities were paying on the bond. It's conclusion was that the vast majority of these bonds were a net drain on government resources, not a contributor.
POBs started as a simple arbitrage game. Cities used the cheap money from tax-free munis to raise millions, then put them into their pension systems where investment managers invested in secure taxable instruments like U.S. Treasuries, which paid a higher interest rate. Congress put a stop to this practice, because it was essentially tax-free arbitrage, with the Tax Reform Act of 1986.
That should have ended POBs. But instead states and cities continued issuing them, but now they instructed investment managers to invest the money in potentially higher-returning vehicles, like stocks. This, of course, also increased the risks. In particular, POBs issued when the market was high, are under water today.
One problem with POBs is that they artificially inflate the funding of pension funds, making them seem in better shape. That actually has encouraged states and cities to add benefits that were actually unaffordable.
Jersey, for instance, floated $2.7 billion in POBs in 1998 and put the money into its pension system. Then in 2001, an election year in Jersey, politicians in both parties rushed to do a big pension benefit enhancement for public employees based in part on funding levels that were the result of the massive debt offering.
However, over the years, Jersey has achieved nowhere near the investment return it projected on that $2.7 billion offering, and meanwhile, annual interest costs associated with it are soaring, having reached $300 million a year in the state's budget. Meanwhile, the state recently fought a bitter battle to reduce the unaffordable pension costs from the 2001 pension enhancement. And the state will be paying off the POB for another 15 years. When it's done, Jersey's interest payments will total $10 billion on a $2.7 billion POB. All in all, a good example of the disaster that these instruments often represent.
thousands of bonds states and cities had issued in order to put money into their pension funds, and then calculated the average returns in stock and bond markets over that time compared to the interest costs that localities were paying on the bond. It's conclusion was that the vast majority of these bonds were a net drain on government resources, not a contributor.POBs started as a simple arbitrage game. Cities used the cheap money from tax-free munis to raise millions, then put them into their pension systems where investment managers invested in secure taxable instruments like U.S. Treasuries, which paid a higher interest rate. Congress put a stop to this practice, because it was essentially tax-free arbitrage, with the Tax Reform Act of 1986.
That should have ended POBs. But instead states and cities continued issuing them, but now they instructed investment managers to invest the money in potentially higher-returning vehicles, like stocks. This, of course, also increased the risks. In particular, POBs issued when the market was high, are under water today.
One problem with POBs is that they artificially inflate the funding of pension funds, making them seem in better shape. That actually has encouraged states and cities to add benefits that were actually unaffordable.
Jersey, for instance, floated $2.7 billion in POBs in 1998 and put the money into its pension system. Then in 2001, an election year in Jersey, politicians in both parties rushed to do a big pension benefit enhancement for public employees based in part on funding levels that were the result of the massive debt offering.
However, over the years, Jersey has achieved nowhere near the investment return it projected on that $2.7 billion offering, and meanwhile, annual interest costs associated with it are soaring, having reached $300 million a year in the state's budget. Meanwhile, the state recently fought a bitter battle to reduce the unaffordable pension costs from the 2001 pension enhancement. And the state will be paying off the POB for another 15 years. When it's done, Jersey's interest payments will total $10 billion on a $2.7 billion POB. All in all, a good example of the disaster that these instruments often represent.
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