While the world awaits more details of the administration's $2 trillion "public-private partnership," which received a skeptical review on Wall Street last week, Ackerman's proposal is circulating among the various public sector pension associations. The idea was presented at one large national pension organization's meeting in Washington as a "good deal," according to one prominent attendee.
In a nutshell, the congressman's idea is that public pension funds have a lot of money ($2 trillion), of which several hundred million dollars are liquid. They need to earn a higher rate of return than they have experienced in the past decade, so Uncle Sam could put their money to work for them by guaranteeing an 8.5 percent return on bank preferred stock as part of the national bailout efforts. In his mind, everybody wins: The pension funds get a high guaranteed return that meets or exceeds their actuarial requirements, and the banks would get long-term, patient money at a cost below current market levels for bank preferred shares, which now trade at 9 percent to 20 percent yields.
Unfortunately, it's not quite all that easy. There are some flies in the ointment, as they say, and public pension professionals and federal policymakers need to carefully think through the following issues:
1. Abusive arbitrage. The idea of a federal guarantee of 8.5 percent returns without some kind of control would invite unlimited Pension Obligation Bond arbitrage, as states and municipalities could immediately sell taxable debt at 6 percent (roughly) and capture a guaranteed positive spread at the expense of federal taxpayers. So that part of this proposal looks dead-on-arrival to me. Why should federal taxpayers subsidize public-sector hedge funds, which is what pension plans would thus become?
2. Is there really critical mass? After the market meltdown, public pension funds have roughly $2 trillion of assets. Even with some kind of federal guarantees or support, I doubt that more than 5 percent of total assets could be invested in this asset class in 2009, without disrupting capital markets and their own portfolios. That is $100 billion potentially, using ball-park numbers. The Ackerman bill itself only provides for $50 billion of guarantees. In light of a multi-trillion-dollar toxic mortgage problem, one question is whether the public-pension sector is large enough to actually make a dent in the problem. Not that it shouldn't be included or considered. But in the context of establishing a major federal program, we all need to be realistic that pension funds by themselves cannot solve the problem or even be a major part of the solution. They probably can't raise more than 5 to 8 percent of the total investment that the Treasury must ultimately facilitate in this workout. As part of a public-private partnership as the Treasury is seeking to achieve, public pensions could be a supporting actor, but it's not a marquee role.
3. Isn't this a pension-fund bailout in disguise? There is great danger in the message (read this news article carefully) that public funds are in such dire straits that they need this federal guarantee of returns in order to achieve their mission. Pension funds need to be part of the solution, not part of the problem. Thus, the publicity spin needs to be carefully managed so that this legislation is not perceived as a bailout of public pension funds.
4. A germ of an idea. The assets do match the liabilities. There is a nascent idea here that is worth nurturing: Public pension funds have long-term, patient capital that can endure the lengthy workout periods needed for these banks and their toxic assets to eventually recover to a value exceeding their current distressed mark-to-market prices. Therein lies the germ of a viable investment idea, and if public pension funds can provide "off-balance-sheet financing" to the feds who provide a partial guarantee with some additional upside, such as participation rights or a convertible preferred structure, then this idea could have legs. Simply investing in traditional bank preferred stock is not the right solution, however. Banks will probably work out of this mess in five or six years, but the toxic mortgages will likely run longer, and that's where pension money has its greatest value.
5. Needed: a better vehicle. If the Treasury Department and the Federal Reserve can devise a well designed public-private partnership that enables private capital to combine with public-pension capital, the scale might be sufficiently large to make a difference. Deciding whether the right vehicle is participating or convertible preferred bank stock -- or an outright participation in a national mortgage pool -- is where the policy focus should be devoted. And public funds need not be guaranteed a rate of return above their own cost of capital. They should bear some risk and receive in return a premium for their patient, long-term capital. For example, a 75 percent guarantee of principal, similar to the federal Small Business Administration loan program, along with upside appreciation rights, would make more sense.
6. Give up the guaranteed-high-return idea. Public pension funds don't need Uncle Sam to solve their actuarial problems. They can invest anywhere in the world if they wish. What they can bring to the table is a pool of long-term capital that doesn't need immediate returns -- and in exchange for providing vital liquidity to today's distressed markets, they should be fairly compensated. They deserve interest rates somewhere between investment grade corporate bonds and junk bonds. If there is some kind of federal backstop support to enable pension fiduciaries to take this now-toxic paper into their portfolios instead of the U.S. Treasury or the Federal Reserve (which are selling a mountain of new debts and dollars) that could be good for the country, state and federal taxpayers, public employers and plan participants.
Ultimately, the question is whether this kind of program is worth the effort for Congress and Treasury's financial engineers to fiddle with it, in light of much-larger problem. There is also the question of who will best represent the interests of public pension funds at the bargaining table when these deals get put together?
Rep. Ackerman deserves an "A for Effort" in his legislative initiative. At least he's got people thinking along terms that might ultimately offer hope for a smart and sensible role for public pension plans to pay in the ultimate solutions to our nation's housing and mortgage market meltdown.
For related ideas on the potential role of state and local governments and pension funds in what I am calling "Stimulus II" follow-on efforts to add more "oomph" to the recently-passed $787 billion stimulus bill, see my companion column.
