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Thursday, September 27, 2012

The usual suspects, part 2

A previous post (Eat, drink, and be merry for tomorrow our pension may die) addressed the city of Stockton's foolish decision to finance its pension debt with bonds.  This New York Times article by Mary Williams Walsh (How a Plan to Help City Pay Pensions Backfired) details how Stockton was assisted in this debacle by Wall Street investment bank Lehman Brothers.   For those who already blame Wall Street for the public pension crisis, this article will serve as a convenient morality play in which evil Wall Street, represented by the now-defunct Lehman Brothers, leads the naive politicians of Stockton down the path of ruin.

The situation in Stockton is a mess with taxpayers, city employees, and retirees left to watch the spectacle of the city government, CalPERS, bond insurers, and other creditors fight it out in court over who gets paid, who gets stiffed, and who gets stuck with the tab.  Lehman Brothers would be involved in this battle as well if it had not gone bankrupt, but Lehman Brothers does serve a purpose by lingering in the background as a ready-made scapegoat.  This allows the Stockton city council, CalPERS, and bond insurers a way to mitigate their poor choices and lack of foresight by utilizing the it's-all-Wall-Street's-fault excuse.

For many people Wall Street occupies the same economic environment as the much-derided "middleman" in the retail industry.  The consumer has been led to believe that the middleman is a superfluous entity whose only purpose in the supply chain is to take his cut and raise final costs.  However, the middleman does provide a service to manufacturers who want to move their goods quickly and retailers who only want to carry enough inventory to match their sales.  If Target or Safeway tried to operate their business like Costco, they would need buildings that dwarfed your typical Costco.

Wall Street exists to facilitate transactions that transfer risk between parties.  Market makers, insurers, investment banks, currency and commodities traders, and brokerages all link up parties willing to buy and sell risk.  This is no different than when a homeowner buys insurance; he is simply transferring the risk of catastrophic loss to the insurer for an annual fee.  The financial system is supposed to price risk based on the likelihood of default, and products more likely to default have higher interest rates.  The problem that will always exist is the danger that risk is miscalculated or that the parties do not understand the true risk of the product they have bought or sold.  This is not to say that there is not fraud or unethical behavior on Wall Street.  In the documentary Enron: The Smartest Guys in the Room, some Enron traders gloated to coworkers when they made a trade that they knew would end badly for the unsuspecting buyer.  How prevalent that type of attitude is on Wall Street would have to be answered by an insider, but regardless, a market for risk-trading exists and Wall Street profits by making that market work.

This post is not meant to be a explanation or history of the Great Recession, and there are several good books like Gretchen Morgenson's Reckless Endangerment,Bethany McLean and Joe Nocera's All the Devils Are Here,Edward Conard's Unintended Consequences,and Michael Lewis' The Big Shortthat do a great job of explaining what happened.  For the city of Stockton, Mr. Lewis' book has the most cogent passage.  He writes about a trader named Danny Moses whose question to any Wall Street firm that tried to sell him on a supposedly risk-free trade was, "I appreciate this, but I just want to know one thing: How are you going to f*** me?"  For Mr. Moses this was not a rhetorical question, and he demanded an honest answer and would trade only if he was told the truth.

Ms. Walsh's article tells how the Stockton city council sensed that the pension bond idea was too good to be true, and one council member even professed ignorance about the bond market. Lehman Brothers eventually sold them on the bond proposal in 2007, but with how much skepticism, willing suspension of disbelief, and unanswered questions from the city council is not detailed in the article.

So how much is Lehman Brothers to blame?  They appear as Harold Hill-like characters selling a dream to gullible townsfolk, but the product actually succeeded in its purpose of transferring risk.  Stockton transferred risk to bondholders and then insured the bonds.  The insurer of the bonds will have to reimburse bondholders for their principal, but the insurer has filed a claim against the city in bankruptcy court.  Depending on how the bankruptcy judge rules, Stockton may get out of this debt at a discount or even scot-free.  This was not how it was supposed to work, but it may turn out to be a good deal for the city after all.

The overarching question is the culpability of Wall Street in the public pension crisis.  The criticism that Wall Street created bad products like mortgage-backed securities and credit default swaps that were destined to crash the market is valid, though bond rating agencies, government regulators, government-sponsored entities like Fannie Mae and Freddie Mac, and institutional investors also share some of the blame.  However, the market has since recovered, and yet, many public pensions are still in bad financial shape.  As convenient as it is to blame Lehman Brothers for some of Stockton's financial problems, the trouble started long before Lehman Brothers ever entered the picture.  The awarding of generous retirement benefits with unrealistic expectations of how they were to be funded is the real reason Stockton is bankrupt.  And so it goes for the public pension crisis.  Even if Wall Street may have helped crash the market, the seeds of the public pension crisis were sown long before the crash.

The next post will cover the last of the usual suspects that get blamed for the public pension crisis: public employee unions.

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