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Market Commentary

California Update
October 17, 2012  David R. Kotok, Chairman and Chief Investment Officer

Some follow-up notes to our commentary about California cities are in order. The most recent news involves San Bernardino and other California cities attempting to defer payments to CalPERS. For a timely article on this subject see “San Bernardino defers CalPERS payments as it pushes toward bankruptcy eligibility” published by DebtWire. http://www.cumber.com/content/special/DWMuniSB1016.pdf

Now let’s incorporate some comments forwarded to us by Sherman Bruchansky, an enrolled actuary for over 30 years and an expert in pensions. We’ve known Sherman for a long time. He is forthright and doesn’t mince words. His response concerning Vallejo and the situation there follows.

“David, I have been following the Vallejo bankruptcy since it first occurred. My reading has informed me that there were no changes to police and firefighter pensions. They were and still are 90% of final year's salary and can begin as early as age 50. Obviously, much overtime is worked in that final year to enhance the pension to over 100% of final pay. I have not seen where the cost of living increases were removed. This means that an officer can work 25 years, retire and collect 5 times or more in retirement than when they working. When I looked at this situation 3–4 years ago the average police officer was making $122,000 per year and the captains were over $200,000. As of this year the average police officer is costing the city $230,000 in salary and benefits and the average firefighter $211,000. For a city of 120,000 people this is unsustainable. Apparently another battle is looming with these unions, since this was not handled during the bankruptcy. As you well know, pensions like these are not available in the private sector under ERISA. The debtors vs. the unions litigation will be here again shortly. Apparently, many CA cities are in this same boat. I find it strange that private company pensions can be curtailed and terminated, but municipal pensions cannot be, or so the unions claim.”

Other commentaries about the California city systemic evolution have flowed from readers, analysts, and reporters who cover those cities in national and California-based media.  Some Wall Street “mavens” have taken the position that the California city problem is “not a big deal.” Those views tend to be centered in the “sell side” where the affiliated firm is in the business of marketing the municipal bonds of many California jurisdictions.  Note: it is hard for a broker to sell a bond when his firm is recommending caution about holding it.  Readers are invited to draw their own conclusions about any biases implied here.

Other views, that are more in agreement with us, seem to be concentrated on the “buy side.”  Buy side analysts are usually more independent and therefore less constrained about making negative or cautionary recommendations.  That said, many are restrained in the degree with which they take positions on risk.  This is especially true when common fund vehicles are used.

Time will tell which view is correct.  Meanwhile, Cumberland’s view originates in a fee for service only management firm.  We do not sell bonds.  We ONLY manage separate accounts and we are state specific in almost all 50 states (I think the current count is 48).  We emphasize risk management and avoidance is problems; thus, we tend to sell early.  This view of preserving capital and diminishing risk is the driver behind our investment conclusion about California.  In sum, we see developments in CA and also in Illinois as the worst two states in the country.  In both, the source of trouble is the underfunded pension systems and the underfunded or unfunded post-retirement benefit systems.

A final point is necessary when it comes to selection of each individual bond.  It is important to distinguish among the various seniority status levels of claims on local budgets. There are differences among these claims. For example, an essential-service revenue bond secured by a first lien on the revenue of a municipal water utility has been upheld by courts as a senior claim. In this example, the bond holders lend money to the municipality, its water utility, or other governmental form. The money is used to drill wells, maintain water lines, process and purify water, maintain reservoirs, and do all the other things that happen when one is engaged in the municipal water business.

The revenues from the sale of the water to municipal users secure, and make the payments to, the bond holders who loan the money to the water company to create the water project. That is usually structured as a senior claim. In addition, the water company promises, through covenants in the bond indenture, to maintain sufficient coverage and financial reserves.  This protects the bond holders, so that they are paid the agreed principal and interest in a timely manner.

In this example, if the town folds up, ceases to exist, becomes a ghost town where no citizens remain and there are no customers to buy water, the water utility bond holders will be in trouble. The bonds will default. That is not the dominant case in the cities we are talking about in California or elsewhere. Why would anyone want to buy the bond of a water utility in a city in which the population was declining, the economic ability to sustain and develop the town was disappearing, and the likelihood that the water company would continue to exist was growing increasingly remote? Anyone who bought such a bond would be guilty of financial foolishness.

The point of the above description is that there are many tax-free municipal bonds issued to support essential-service revenues. These bonds have senior claims and are very well protected. The bond holder can expect payment of principal and interest in a timely manner, even when circumstances in the economic arena are adverse.

That safety is not the case when payment streams are funded without such detailed and legally upheld structural commitments.

We see examples of the latter case taking place in California cities where lease bonds, certificates of participation, and other forms of indebtedness are being used to finance these cities. These are weaker claims that are not tied to specific general obligations or specific revenue liens. They are more likely to be tied to the availability of monies in the general funds of the cities.

What happens when the city is trying to use Chapter 9 bankruptcy or other legal forms to diminish its payments? Standard & Poor’s has warned about cities engaging in the use of Chapter 9 to avoid payments. “Willingness to pay” is the code term for the political resolve of a city governing body to meet obligations.

So what happens in these communities? In order to demonstrate that they have a financial emergency, they must, by definition, not be able to make payments. So they play games with municipal budgeting in order to weaken the credit structure of the more questionable types of bonds, notes, certificates, or lease payments. The communities can then go to the state and say they do not have the money; therefore they have an emergency and need help.

At Cumberland Advisors we are avoiding this level of weaker credit. We don’t want to own it. We don’t advise clients to buy it. If a client brings a portfolio into our firm for management and the client has already purchased this type of bond, we will advise that it be sold.

In sum, don’t lend your money to a municipal government, or any government, that is not actively demonstrating the commitment and willingness to pay you back. If you do, you engage in financial foolishness.

In Cumberland’s view, there is a systemic problem in California. It is rooted in the pension system, which has promised more than it can deliver. California has enacted legislation that is supposed to address this problem over a long period of time, but we are highly skeptical as to whether the legislation is sufficient. We also think the economic assumptions that led to the legislation may be flawed. We will not know for several decades whether the legislation can cure the pension problem. Meanwhile, as investment advisors, we do not want our clients to find out the hard way.

Our position continues to be that there is systemic municipal risk in California. It is evolving in the cities now and is likely to spread. The old cliché applies: there is never just one cockroach. In this case, we already know there is an infestation of cockroaches in California, and they seem to be spreading.

David R. Kotok, Chairman and Chief Investment Officer

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