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How States Became Shadow Bankers

State borrowing to finance employee pension buyouts will only fuel equity bull market, an analyst says.

Illinois and Minnesota may soon issue debt so the states can buy back some pension benefits from public employees, moves that may further inflate the credit-led equity bull market.

According to Brian Reynolds — an analyst at Canadian investment bank Canaccord Genuity — the cash that state and local municipalities have poured into their pensions over the last decade to improve financial health has mostly ended up in credit funds, which have then helped public companies do stock buybacks and inflate equity markets. State legislatures in Illinois and Minnesota put provisions in recent budgets that would allow them to issue debt for buy-outs and to cut costs. The moves will add further cash to the bubble, in Reynolds’ view. 

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“Every few weeks, we find more pensions finding ways to intensify the credit boom,” Reynolds wrote in a recent note to clients on shadow banking. “This is why fresh new tax money going into credit is growing at an increasing pace, why these flows are growing more than twice as fast as nominal GDP, and why they are now increasing by more than the federal tax cut that was enacted late last year.” In the research note, Reynolds said he expects the bull market to continue for another three to five years because of the flow of pension money into credit.

Asset managers have launched thousands of private credit funds to pick up the slack after banks curtailed much of their riskier lending post-2008. Pension funds, insurance companies, and others have been eager to invest in private credit for the extra yield above publicly traded fixed income. Credit funds, which lack the transparency of bank lending, have also distorted the markets, argued Reynolds, who described them as part of a larger shadow banking system that has emerged in recent years. 

The State of Illinois estimated that its contribution to the pension system will rise from $8.4 billion now to more than $10 billion annually within four years. Even with that, the state’s pensions owe $129 billion more than they have. Their investment teams have turned, as a result, to higher-yielding assets, such as private credit. If the state issues $1 billion in debt, as Illinois is now allowed to do, and was able to buy out some of the benefits it offers to employees, it would save about $423 million. Once completed, however, a smaller pension plan may have to invest more aggressively to compound at a similar rate. Reynolds said that could push even more money into private credit.

Nevertheless, Reynolds believes Illinois’ buyout plan would make sense for workers, particularly older ones, and for the state. Illinois’ unfunded pension liabilities are compounding at 7 percent. By issuing debt at a lower rate, the state could save about 1.75 percent for every dollar that it bought out, he said. The Canaccord analyst expects other states to follow Illinois with similar buyback plans. 

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