BILL ANALYSIS
AB 2364
Page 1
Date of Hearing: May 5, 2004
ASSEMBLY COMMITTEE ON PUBLIC EMPLOYEES, RETIREMENT AND SOCIAL
SECURITY
Gloria Negrete McLeod, Chair
AB 2364 (Correa) - As Amended: April 26, 2004
SUBJECT : Public pension systems: credit enhancement.
SUMMARY : Authorizes public pension systems to establish credit
enhancement programs to assist issuers of municipal and public
finance debt, as specified.
EXISTING LAW Declares that the retirement boards of public
pension and retirement systems have fiduciary responsibility
over the assets of the public pension or retirement system.
FISCAL EFFECT : According to CalPERS despite the obvious risk
associated with any investment program that CalPERS administers,
the fund is expected to receive fee income which would make the
credit enhancement program an income producer. The following
information on fee generation has been provided by CalPERS.
Credit Enhancement Program: Size and Fee Income Generation
While the Investment Committee will decide how much of CalPERS
contingent liability it will allocate to this fee generating
program, the rating agencies generally deem as prudent 5-10% of
total market value of assets (or $7-15 billion). Staff suggests
that a 2% allocation (or approx. $3 billion) would be
appropriate as its initial allocation .
Fees will be generated from annual commitment fees, up-front
structuring fees, interest on funded bond purchases, operational
draws, and amendment and waiver fees. In developing fee
projections, staff has consulted widely - drawing from a
financial institution's 25-year history of providing credit
enhancement of municipal bonds. As a result, staff is
comfortable that, within a fairly narrow range, credit
enhancement fees should be sufficient to provide net returns to
CalPERS of 40 basis points per annum . For CalPERS, the chart
below demonstrates the projected gross fee income and
outstanding commitments for the CEP. Initially, annual business
expenses of approximately $75,000 are contemplated for limited
due diligence travel and yearly rating agency surveillance fees.
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| | Year 1| Year 2| Year 3|
|-----------------------------+-----------+-----------+-----------|
| | | | |
|Total CalPERS' CEP Portfolio | $1.0 Bil| $2.0 Bil| $3.0 Bil|
|($ Billion) | | | |
|-----------------------------+-----------+-----------+-----------|
| | | | |
|-----------------------------+-----------+-----------+-----------|
|Minimum Projected Fee Income | $4.0 Mil| $8.0 Mil|$12.0 |
|($ Million) | | |Mil |
-----------------------------------------------------------------
COMMENTS :
BACKGROUND - The committee is advised that the following
background information is an excerpt of a study prepared by
CalPERS Investment Staff. The full study is provided for each
committee member with the analysis.
One of the new programs CalPERS Fixed Income staff has proposed
under the 2002-03 Annual Plan is to establish a Credit
Enhancement Program ("CEP"). Staff has been exploring program
options to provide credit enhancement to support infrastructure
development throughout the United States, including the
feasibility of working with a Strategic Partner/Third Party
provider willing to participate in every transaction with
CalPERS on a pro-rata basis, and/or in conjunction with a
Consortium of large public U.S. pension funds led by a large
U.S. financial institution
The primary objective of the CEP is to earn fee income. The fee
income is pursued on an expected zero loss underwriting basis.
Risk minimization is a desired objective, which may result in
lower fee income. The CEP will be an off-balance sheet
component of the Investment Portfolio, enabling CalPERS to use
its asset base and liquidity strength to generate fee income, in
circumstances that are expected to be highly infrequent. As a
result, the Strategic Asset Allocation plan is not likely to be
affected.
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Description and Definition
Credit enhancement is a substitution of a highly rated financial
institution's credit rating for that of a lower rated public or
private entity. It is an agreement by a third party (CalPERS)
to pay the investor scheduled interest and/or principal payments
in the event the primary obligor does not meet the terms and
conditions of the bond indenture. This substitution (for a fee)
allows the public or private entity access to the capital
markets at a lower interest rate. The most utilized form of
credit enhancement is a financial instrument known as
letter-of-credit (LOC). An LOC is an unconditional promise to
make payments up to a stated amount for a specified period upon
receipt of a proper notice. The commitment is irrevocable.
Another form of credit enhancement is called a "liquidity
enhancement." Liquidity enhancement is used for short term or
variable rate securities to give investors confidence in the
amount of liquidity associated with a specific security. Most
liquidity enhancements contain a lesser degree of credit
exposure than LOCs.
The following types of LOCs are utilized:
1.Direct Pay Letter-of-Credit. For this letter-of-credit, the
investor (through the Trustee) looks to the Direct Pay LOC
Bank (could be CalPERS) for all interest and principal
payments to investors. The obligor (company or municipality
seeking credit) then reimburses the Direct Pay Bank. If the
obligor fails to reimburse for the LOC drawing, the fronting
bank, with the first loss position in the obligor's
creditworthiness, reimburses CalPERS (Direct risk or 1st loss
position).
2.Confirming Letter-of-Credit. For this LOC, the investor
(through the Trustee) looks to the bank supporting the obligor
to make the interest and principal payments to investors. If
the bank fails to make these payments, the Trustee calls upon
CalPERS to make the payment. CalPERS would then demand
reimbursement from the bank (Indirect risk or 2nd loss
position).
3.Liquidity Facility. This form of LOC is an availability to
purchase securities under specific situations. The bonds or
commercial paper that this facility supports may be remarketed
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on a daily, weekly, or monthly basis. There is a need to have
their marketability guaranteed to SEC standards (247 Rule).
If there is a failed remarketing, CalPERS may be required to
"purchase" these bonds and receive pre-agreed interest
payments. In the case of a liquidity facility, the commitment
may terminate immediately (Indirect risk or 2nd loss
position).
OVERVIEW OF CALSTRS' CREDIT ENHANCEMENT PROGRAM
In 1992, the California State Teachers' Retirement System
("CalSTRS") commenced a study to determine the feasibility and
prudence of establishing a CEP in order to earn incremental fee
income for the system. In May 1993, CalSTRS' Investment
Committee authorized the funds to secure credit ratings from
Standard & Poors ("S&P"), Moody's Investors Service ("Moody's"),
and Fitch IBCA ("Fitch'), the three most widely used credit
agencies. Subsequently, CalSTRS received a AA+ long term rating
and a A1+ short term rating from S&P, a Aa2 long term rating and
a P1 short term rating from Moody's, and a AA+ long term rating
and F1+ short term rating from Fitch. Policies and procedures
for the CEP were first completed and approved in February 1994
and most recently updated in April 1999. Subsequently, Moody's,
S&P and Fitch raised their respective ratings of CalSTRS to
Aaa/AAA/AAA - the highest possible ratings.
During their presentation to the Investment Committee in May
1993, CalSTRS identified the targets of their CEP program as
follows:
Five Year Target for Outstanding Balances -- $1 billion
(1% of total assets or 2% of a $50 billion market)
Five Year Target for Fee Income -- $2 million per annum
(20 basis point average)
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CalSTRS: Outstanding Commitments
CalSTRS' CEP program is limited to 2% of total assets. As of
March 31, 2002, it was running at 1.25% of total assets. The
outstanding commitments have increased an average of 35% over
the past three years. Annualized fees have also increased an
average of 29% over the same period. Annual business expense
runs approximately $60,000 for rating agency surveillance fees.
Approximately 2 FTE divided over 4 people are currently required
to manage the program.
CalSTRS executed its first credit enhancement in June 1994 when
it provided a $25 million liquidity facility in favor of the
Port of Long Beach. Since then, CalSTRS has aided more than 100
California issuers with credit enhancement for industrial
development bonds, multi-family housing bonds, pollution control
bonds, municipality bonds, healthcare-related bonds, and other
private activity bonds.
The committee is advised that more information on the CalSTRS
program, as well as side by side comparisons with the proposed
CalPERS credit enhancement program is included in the attachment
which follows this analysis.
Arguments in Support
The committee is advised that the following Questions and
Answers were provided by CalPERS, the sponsor of AB 2364.
What is Credit Enhancment?
Credit enhancement is the substitution of a highly-rated
financial institution's credit score for that of a lower-rated
public or private entity. The advantage for those entities
purchasing credit enhancement is that they are able to obtain
financing at lower interest rates than would otherwise be the
case, resulting in immediate savings.
What will this bill do?
This bill will clarify in law the ability of public pension
funds, such as CalPERS, to provide credit enhancement to state
and local governmental entities in exchange for a transaction
fee. The performance of municipal bonds financed via credit
enhancement could also be guaranteed by CalPERS.
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Why does CalPERS wish to enter the credit enhancement market?
The difficult economic climate has created an increasing need
for credit enhancement. By providing credit enhancement,
CalPERS expects to generate significant revenue in fees,
estimated at four million dollars in the first year. CalPERS
will also provide a benefit to governmental entities by acting
as a guarantor in their bond transactions, allowing them the
benefit of lower interest rates due to CalPERS' superior credit
rating.
Isn't credit enhancement traditionally a function of the private
sector?
Yes. But relatively few private sector entities in the credit
enhancement market have an AAA rating, and of those that do,
many cannot meet the increasing demand for credit enhancement in
California. Demand for credit enhancement tends to increase
whenever there is a downturn in the economy, as governmental
entities struggle to fund long-term capital improvement
projects. At the same time, in recent years, many local
governmental entities have had their credit ratings lowered, as
has the State of California. CalPERS can help to meet the
escalating demand for credit enhancement triggered by our
current economic climate.
Will providing credit enhancement endanger CalPERS' Retirement
Fund?
No. Defaults in the municipal bond market are rare, less than
one percent. CalPERS employs rigorous underwriting standards
designed to minimize risk. For example, governmental entities
that have defaulted on loans or gone into bankruptcy during the
past 15 years would not be eligible. Risk will be further
minimized by diversifying the portfolio by sector, credit
quality, and geographic location. Finally credit enhancement
will be limited to a small percentage of total assets (between
two and ten percent), thereby providing the Fund an additional
layer of protection.
Why should government entities go to CalPERS for credit
enhancement when they can get the same product in the private
sector?
The private sector alone cannot meet the current escalating
demand. CalPERS will offer a competitive product due to its
superior credit rating. CalPERS is currently seeking a credit
rating from Standard & Poor's, Moody's, and Fitch. The System
is expected to receive an AAA credit rating, allowing CalPERS to
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enter the credit enhancement market in a position superior to
that of many other private sector entities. Relatively few such
entities have an AAA rating.
Why should this be an urgency measure?
Cash flow pressures on governmental entities tend to worsen
during difficult economic times. Given our current economy, and
the increasing demand for credit enhancement, this measure, by
facilitating high quality credit enhancement at lower rates,
will aid governmental entities trying to weather the economic
storm.
REGISTERED SUPPORT / OPPOSITION :
Support
CalPERS Board of Administration
Opposition
None on file
Analysis Prepared by : Clem Meredith / P.E., R. & S.S. / (916)
319-3957