A look into the ZeroHedge vs. Illinois Teacher's Retirement Fund Spat, We still have some unanswered questions..

Reggie Middleton's picture

Zero Hedge posted an interesting response from the Illinois Teacher’s
Retirement System that basically stated their dislike for Tyler
Durden’s characterization of a “death spiral” in relation to their need
to sell off assets (see Illinois
Teachers’ Retirement System Enters The Death Spiral: AIG Wannabe’s
Go-For-Broke Strategy Fails As Pension Fund Begins Liquidations
).
The response had a very cogent and common sense reason for the asset
sales, even thought they occurred at a very inopportune time. See TRS Responds to “Death Spiral” Comments.

We at the BoomBustBlog commented on the Illinois TRS on August 23rd: Is Illinois Worse Off Than Greece

In reviewing both our comments and the responses from TRS, it begs
the question as to why TRS officials failed to address some of the more
salient points in our missive. To wit, let’s excerpt a portion from our
note, linked above:

Illinois Budget Crisis Draining State Services: Bloomberg

  • State retirement liabilities are near $130 billion, Illinois holds the country’s largest pension and health care funding gaps
  • Pension debt is $90 billion, and programs are unfunded to the tune of $54 billion
  • The state’s unpaid bills have risen by $1 billion in the past year

Chicago Downgrade Raises Borrowing Costs Amid $164 Million Sale: Bloomberg

  • Chicago is planning a multibillion dollar education capital plan, which it will debt finance
  • Chicago has continued to thin out its cash reserves, and when
    faced with firing 1,200 public school employees, it instead chose to
    let the good times roll (party like its 2005)
  • Recent credit ratings downgrades may have raised the debt financing cost by 40%

Illinois Pension Continues to Borrow From Future: Sun Times

  • In January of this year, Illinois raised $3.5 billion in five
    year pension obligation notes at a tax free rate of 3.84%, most of the
    funds going to the Teachers Retirement System (TRS)
  • The pension fund usually reinvests some of the proceeds
    from the bond sale into financial markets to try and beat the 3.84%
    interest rate, however, in 2009, the TRS fund lost 22%, even as the
    S&P 500 strengthened by 26%
  • The pension system has reached an endpoint where simply cutting
    future benefits will not be enough to get out of a fatal debt spiral

Perhaps the only thing more frightening than the TRS asset shortfall is the TRS asset holdings
Illinois has exposed itself to material credit risk and CRE exposure
through their CMBS holdings. I assume an astute sales team sold this to
the pension fund. For more on the profitability (for the banks) on
selling CRE products to institutions, see When It Comes to Wall Street Real Estate Funds, the House Always Wins – Even When Investors Get Slaughtered
(it’s long, but it drives the point home). TRS has also assumed (and
probably generated) material global credit risk in the OTC credit
derivatives market by underwriting sovereign CDS on government bonds.  An audit of fund holdings indicates that these positions have lost $515 million,
with the audit occurring at the end of March 2010, so it is ok to
assume that these positions have become even worse as spreads have blown
out in Europe.  For those who are not aware of my stance on credit
risk as well as the financial and economic contagion hotbed boiling in
Europe amid the rampant mis(and dis)information , see my series on the Pan-European Sovereign Debt Crisis.

Hey, Mr. and Mrs. Illinois Teacher, Reggie Middleton thinks your pension fund is picking up pennies in front of a freight train!

So, we have teacher’s pensions writing insurance on the biggest
European debacle of this century. We have same said pension buying the
debt of assets, 40% of which are probably underwater.
What was not mentioned thus far is that this very same pension has
more than 80% of its holdings considered “risky” according to a study
by “Pensions and Investments”, and industry rag – and that was in 2008,
without the benefit pending defaults in Europe and the ever higher
climb of LTVs in CRE.

Then there’s the fact that TRS is also:

  • selling swaptions,
  • shorting international interest rate swaps
  • knee deep in GNMA, FNMA instruments,,,,

and this is just from a cursory view of their holdings. They paid
over $160 million in management fees, and if I had to take a guess,
they are reaching for yield and quick returns over the prudence of
looking to preserve capital which in my opinion should be the mantra of
a pension fund shepherding the retirement funds of real people. Then
again, there I go being old fashioned again.

In addition to the market performance of the actual positions
themselves, one must ponder… If a credit event is triggered, does the
Illinois TRS have the liquid capital to make good on its CDS
obligations? When BoomBustBlog created the Sovereign Contagion Model,
who knew it left out Illinois.  If the TRS is unable to make good on
its CDS positions in the event of a tail event, it is definitely not
unfathomable that Illinois could be the domino that falls into the blow
up the CDS market.

Illinois is facing what Hayman Capital Advisors manager Kyle Bass
referred to as “The Keynesian Endpoint”.  To paraphrase, when debt
service exceeds revenue, deficit spending becomes permanent and
structural until default inevitably occurs.  Since the bursting of the
housing and credit consumption bubble back in 2008, tax revenues have
fallen, and pension liabilities continue to receive funding through debt
markets.  Using basic accounting, the gimmicks used to placate state
employees are about to come to an end.

There are more charts and graphs that generate even more questions from inquiring minds in the original BoomBustBlog post, Is Illinois Worse Off Than Greece…, but I think what I have excerpted here should serve to stoke the inquisitive mindset.

If TRS wishes to dispel notions of its insolvency, addressing the issues listed above would be a very, very good start!.

It appears as if ZeroHedge may have the last laugh, at least
according to this Bloomberg TV interview they posted today. The interviewee also brushes
up against the CRE issue, although ever so briefly.

Illinois’ $10 Billion Pension Time Bomb