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Cassius Marcellus Coolidge
Doubling Down on Dumb Ideas
“Scared money never wins” ~ anonymous gambler’s saying.
The rise and fall of Orange County
In 1994, Orange County, California, announced that its investment portfolio had lost a staggering $1.6 billion. This was shortly followed by the bankruptcy of the County. Before these events, Robert Citron, the County’s Treasurer, who was in charge of the County’s investments, had been hailed as a 'genius' whose stewardship had delivered above-average returns (2% higher than other public funds). Among other things, these returns were projected to ensure that the city's future pension obligations would be met.
How did he do this? He had moved away from traditional low-risk investment practices and loaded up on derivatives and leverage: high-risk investing with borrowed money—money that had been obtained by issuing public debt. Mr. Citron’s management was so applauded that smaller agencies, such as local school districts, borrowed money and gave it to Citron to invest for them.
All was well until the economy started to wobble after the Federal Reserve started raising interest rates. Suddenly, the fund's fortunes began to reverse. Within less than a year after the announcement of its losses, Orange County was forced into bankruptcy and Mr. Citron was shown the door. Mr. Citron's gamble to earn big returns without raising taxes, through the use of risky derivatives and highly leveraged positions was a double-edged sword.
In other words, the theory that taking on more risk in risky times was less risky than not taking risks and failing to meet the County’s pension obligations was a dumb idea.
Apropos of this cautionary tale, the Wall Street Journal recently reported that
“U.S. public pension funds don’t have nearly enough money to pay for all their obligations to future retirees. Even the longest equity bull market in history—a roughly 11-year run through early 2020 in which the S&P 500’s 18% annual return more than tripled its historic average—didn’t close the gap between pension funds’ obligations and assets. In 2021, public pension plans had an average of just $0.75 for every dollar they expected to owe retirees in future benefits.”
So, how do these public investment funds intend to fix this?
Again, according to the WSJ,
“A growing number are adopting a risky solution: investing borrowed money. Next month, the largest U.S. public-worker fund, the roughly $440 billion California Public Employees’ Retirement System, known as CalPERS, will add leverage for the first time in its 90-year history.”
“While most pension funds still avoid investing borrowed money, the use of leverage is spreading faster than ever. Funds have [also] dipped more heavily into private-market investments. They have ramped up alternative investments, such as hedge funds, real estate, private-debt funds that make unrated loans, and private-equity funds that buy, overhaul and sell companies.”
With inflation and interest rates rising, stock markets falling at a historic pace, and with the country looking like it’s already in or heading into a recession or at the least years of stagflation, one has to wonder about their timing.
It’s bad enough that pension agencies (such as CalPERS) have proven incapable of achieving their minimum investment return benchmarks to meet their retirement obligations for the past decade, but do we really trust that their foray into high-stakes leverage and derivative gambles will do any better?
When will we learn our lesson?
Let’s put on a play!
According to a new report by SPUR (the San Francisco Bay Area Planning and Urban Research Association: a nonprofit public policy organization) and The Terner Center at Berkeley, what the world needs now is for cities and counties to get into the housing business by creating new housing development agencies using joint powers authorities (JPAs) and to fund these new agencies using... you guessed it... borrowed money. (Mr. Citron would be proud.)
JPAs are collaborative, quasi-governmental agencies. As described in a 2007 report, Governments Working Together, by Trish Cypher and Colin Grinnell:
“Joint powers are exercised when the public officials of two or more agencies agree to create another legal entity or establish a joint approach to work on a common problem, fund a project, or act as a representative body for a specific activity.
“Agencies that can exercise joint powers include federal agencies, state departments, counties, cities, special districts, school districts, redevelopment agencies, and even other joint powers organizations. A California agency can even share joint powers with an agency in another state.”
It sounds good but in practice, JPAs can quickly become facilitators of the government’s version of ENRON-like “off-ledger” accounting – taking actions and issuing debt that is, for all intents and purposes, unsupervised.
In the proposals being advanced by SPUR and the Terner Center, these new “housing” JPAs would not only enjoy more expansive tax exemptions but could offer private developers many types of incentives to build, and in partnership with private developers these JPAs could develop their own projects or purchase or construct housing, financed by borrowing money, (selling bonds backed by the revenues from the housing properties they develop: known as “project-based” debt) and they could use leverage by investing in derivatives to increase their borrowing power.
According to SPUR and The Terner Center for Housing Innovation,
“With housing prices out of reach for many, California is facing the need to find new ways to create housing affordable to middle-income households. While there are housing subsidy programs for low-income households, very few tools exist to close the gap for middle-income households, those who earn between 80 and 120 percent of the area median income. A promising new model—joint powers authority (JPA) owned middle-income housing—allows cities and state-established financing authorities to act jointly to issue bonds and acquire or construct housing that is not subject to property taxes.”
As the Report explains it,
“The benefits of the JPA model are two-fold. First, the JPA is eligible for tax exemptions on the property it holds. This can lead to substantial financial benefits to the owner of the property, which can be passed on to the renter in the form of lower rents. Just as government-owned properties like city halls, roads, and parks are not taxed, JPA-owned middle-income housing is not taxed.
“Second, JPA-owned middle-income housing can use tax-exempt bond financing. Governmental entities have broad authority to issue tax-exempt bonds.”
Simply put, The Terner Center’s proposal is for cities and counties that have absolutely no experience or expertise whatsoever in developing or managing housing and who will have to rely on the financial projections and proposals from private developers, will suddenly be able to become “housing developers” and would do so using derivatives and borrowed money, which would ultimately be backed by general funds and the obligations of taxpayers.
Does anyone really believe that’s a good idea?
The 1988 Savings & Loan Crisis
“History doesn’t repeat itself but it often rhymes” ~ Mark Twain
Investopedia defines the causes of the 1980s S&L Crisis as follows,
“The roots of the S&L crisis lay in excessive lending, speculation, and risk-taking driven by the moral hazard created by deregulation and taxpayer bailout guarantees. Some S&Ls led to outright fraud among insiders and some of these S&Ls knew of—and allowed—such fraudulent transactions to happen.”
Similar to today, the late 1980s were a time when the basic mechanisms of our economy and the assumptions they were based on were being tested. And despite the assurances of financial “experts” at the time that the convoluted schemes being used by banks were sound, many banks failed.
In the early 1990s, our firm acted as a registered federal Resolution Trust Corporation (RTC) contractor. We evaluated the physical and financial condition of defaulted, multi-family properties for institutional investors to structure "workout" proposals / offers to the RTC on R.E.O. ("real estate owned)" property portfolios.
Many of the properties in default were backed by municipal bonds (i.e., the taxpayers); projects that had been optimistically underwritten but were poorly planned or managed or both and had failed to generate sufficient revenues to service the debt.
Much of the debt on these properties was “project-based,” meaning that the only source of revenue to pay off the bonds was the rent (and vending machine revenues) paid by tenants. But as the properties continued to lose money and operating costs rose (insurance, utilities, etc.) and interest rates rose (making refinancing impossible), repairs went unattended, vacancies rose, and the debt eventually went into default for non-payment.
In the end, the debt holders (those who bought the city or county bonds) got "crammed down" to pennies on the dollar and the properties themselves sold at auctions for pennies on the dollar in the subsequent "work-outs." This resulted in cities and counties losing their favorable credit ratings. As a result, "project-based" debt on multi-family development was disallowed (for a time) on federally funded, multi-family projects.
Now, the ”experts” at SPUR and the Terner Center are once again gushing about the prospect of creating yet another leveraged, financing scheme managed by a housing development JPA.
What could possibly go wrong?
In times of turbulent markets, such as now, the odds that the future is unforeseeable increase exponentially. As such, it takes fewer things to go wrong to bring down an entire enterprise, no matter how well planned or executed. In times like these, it’s prudent to decrease risk and leverage, not increase it.
As a hedge fund manager on a financial news channel recently commented, “It’s okay to be a coward [about risk] these days.”
Redevelopment Agencies Redux
In 1945, California created local Redevelopment Agencies funded primarily by local allocations of property tax revenues. Over the subsequent decades, they played an important role in residential and commercial development. On February 1st of 2012, the California Supreme Court dissolved these redevelopment agencies, ostensibly, due to the need to find more revenues for schools and special districts.
In truth, there were other reasons.
Although Redevelopment Agencies did some good over the years, funding infrastructure and redevelopment projects like Old Pasadena and San Diego’s Gas Lamp Quarter, they had also increasingly become a “trough” of public funds where special interests fed without restriction.
As reported by the Los Angeles Times, Los Angeles County Board of Supervisors Chairman Zev Yaroslavsky said at the time that Redevelopment Agencies,
"…evolved into a honey pot that was tapped to underwrite billions of dollars worth of commercial and other for-profit projects." The projects "had nothing to do with reversing blight, but everything to do with subsidizing private real estate ventures that otherwise made no economic sense.”
In its ruling, the Court generally agreed with this assessment. What had started out as a good idea had become a backwater of corruption and political favoritism with little regard for the communities it impacted or the displacement of low-income residents.
What the Terner Center is proposing is, essentially, the recreation of these failed redevelopment agencies, once again without any checks and balances. Why should we believe that the results will be any different this time?
If having local development agencies are a good idea, then they should be fully funded and fully staffed to plan and develop housing without relying on private developers, whose interests are always inherently conflicted with those of the public. Public agencies should only engage real estate industry professionals as competitive bidders responding to published RFPs (Requests for Proposals) for planning, architecture, engineering, financial feasibility and underwriting, project management, or construction contracting services.
The irony is that these agencies already exist. There is no need to create yet another layer of JPAs or regional agencies. We already have local city and county housing authorities.
Local housing authorities were once robust organizations, most capable of doing all the things described above. But today, in many instances (such as the Marin Housing Authority here in Marin County), they are understaffed, under-funded, technically bankrupt, zombie organizations that have been reduced to being Section 8 voucher processors and slumlords overseeing hundreds of distressed units that they cannot afford to maintain.
While the California state legislature has been self-righteously binging on unfunded housing mandates, draconian punitive measures, and laws to give more and more control to private real estate interests, our housing authorities remain the shameful legacy of 40 years of federal and state and local government neglect.
Coda
One might ask, since housing agencies already exist and they already have the capability to join or create JPAs, if they choose, why are SPUR and the Terner Center promoting yet another layer of governance? The answer is that SPUR and the Terner Center represent well-funded interests that want to create a new form of unelected, unaccountable, "regional" governance that can operate without checks and balances, out of the public's eye, much as the San Francisco Bay Area Metropolitan Transportation Commission (MTC) and its wholly-owned subsidiary, the Association of Bay Area Governments (ABAG) do, today.
Bob Silvestri is a Marin County resident, the Editor of the Marin Post, and the founder and president of Community Venture Partners, a 501(c)(3) nonprofit community organization funded by individuals and nonprofit donors. Please consider DONATING TO THE MARIN POST AND CVP to enable us to continue to work on behalf of California residents.