Bloomberg: California’s $600 Billion Sinkhole

California’s next generation got some good news recently when Assembly Speaker John Perez called upon lawmakers to act this year to find a solution to the state’s largest fiscal issue — the $80 billion unfunded liability of the teacher pension system.

Perez’s urgency was in contrast to the timeline proposed by Governor Jerry Brown, who in January acknowledged the severity of the crisis but suggested a solution be put off until next year.

Perez cited one pressing reason for immediate action: the teacher pension debt is growing by $22 million per day. But there’s another reason that politicians in California never discuss: If they don’t act, the obligation will end up costing more than twice as much as it would if they took immediate action. That’s because, in the absence of action, the teacher pension debt will be subject to the same rules as a zero-coupon bond.

Let’s say you borrow $100 at 6 percent a year, due in 30 years. With a normal bond, you would pay coupons of $6 per year for 29 years and then $106 in the 30th year, for a total of $280. With a zero-coupon bond, however, you would pay nothing for the first 29 years and a single “balloon payment” of $574 would be due in the 30th year. That is, the convenience of paying no interest for the first 29 years means you end up paying more than twice as much because of compound interest.

When a corporation issues a zero-coupon bond, it must report (“accrue”) an interest expense on its books each year even though it doesn’t need to make any cash outlays to meet that expense. Accounting for the expense that way is important because otherwise stakeholders (creditors, employees, shareholders and suppliers) wouldn’t know the true size of the company’s expenses or that it had a large obligation for which it will later need lots of cash.

But state and local governments aren’t required to report such future obligations in their annual budgets. Because they get to use “cash-based” budgeting — which reflects only cash that is spent — governments don’t need to show an expense for a zero-coupon bond until the single, final payment is made.

Put another way, unless governments set aside cash in advance of the maturity of a zero-coupon debt, those obligations build up expensively and invisibly until they come due. Worse, the bill is most likely to be presented to an unsuspecting future generation. For example, the Poway School District near San Diego used a zero-coupon bond to borrow $105 million in 2011. A future generation will be required to pay almost $1 billion -– nine times the borrowed amount -– when the bond matures in 2051.

When the Poway deal was exposed, California Treasurer Bill Lockyer quickly proposed legislation to rein in the ability of school districts to issue “abusive” zero-coupon bonds. Later, after Brown signed the legislation, Lockyer said “school districts no longer can heap outrageous debt burdens on the backs of future generations.”

That’s an accurate statement — but it only applies to some zero-coupon obligations. The legislation didn’t address the largest school-related zero-coupon obligation of all: the unfunded liability for teacher pensions.

That obligation functions exactly like a zero-coupon bond. In both cases, cash payouts are promised for the future, though insufficient provisions are made to meet that obligation. In both cases, the single, final payment is many times the debt.

Some money has been set aside for teacher pensions in California but not nearly enough, and the state is already short $80 billion. But that is merely the value of the liability today. Unless cash is set aside, the shortfall will continue to grow zero-coupon style -– until it reaches more than $600 billion when the debt comes due in 2043.

To put that sum in perspective, it is 13 times the amount California’s general fund will devote to K-12 education this fiscal year and 11 times the amount that general fund will spend on everything else. Even if general fund revenue rises at a healthy pace until 2043, $600 billion will be the equivalent of two to three times the state general fund’s spending that year.

To prevent a fiscal apocalypse, last year the California State Teachers’ Retirement System asked Brown and the State Legislature for a 30-year cash injection of $240 billion, starting with $4.2 billion a year. But so far Brown’s budgets haven’t set aside a penny. As a result, the teacher pension debt has grown more than $25 billion since he assumed office in 2011.

Brown’s reluctance to address the issue is easy to understand. California’s zero-coupon pension debt gets little press attention and the payment won’t fall due on his watch. And setting aside billions today in order to prevent a future catastrophe isn’t always the best strategy for winning votes (Last week, Brown announced his bid for re-election).

That’s why Perez’s remarks are a good beginning. Now it’s time for some tangible demonstrations of courageous leadership. To start, Perez, state Senate President Pro Tem Darrell Steinberg and Brown need to commit to providing at least $4 billion this year to CalSTRS. This is the year to start because Brown is forecasting a budget surplus as a result of a frothy stock market and rightly worries about declining revenue when markets cool off.

Absent action, the debt will continue its stealthy growth with devastating consequences for the next generation.

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