BILL ANALYSIS
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THIRD READING
Bill No: AB 2364
Author: Correa (D)
Amended: 5/24/04 in Assembly
Vote: 27 - Urgency
SENATE PUBLIC EMP. & RET. COMMITTEE : 4-1, 6/21/04
AYES: Soto, Ashburn, Escutia, Karnette
NOES: Oller
ASSEMBLY FLOOR : 77-1, 5/26/04 - See last page for vote
SUBJECT : State pension systems: credit enhancement
SOURCE : Public Employees Retirement System
DIGEST : This bill authorizes state pension systems to
establish credit enhancement programs to assist issuers of
municipal and public finance debt, as specified.
ANALYSIS : Existing law declares that the retirement
boards of state pension and retirement systems have
fiduciary responsibility over the assets of the public
pension or retirement system.
This bill authorizes all state pension systems to establish
credit enhancement programs to assist issuers of municipal
and public finance debt, as specified.
Credit enhancement programs allow the substitution of PERS'
credit rating for that of a lower rated public or private
entity to assist entities to secure more favorable
CONTINUED
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financing terms by a variety of types of credit
enhancement, including but not limited to enhancing the
credit of bonds, notes and other indebtedness. For
substituting its credit rating, PERS would earn income
based on fees charged for each credit enhancement
transaction. (An expanded discussion of credit enhancement
programs is provide in Comments #2 below)
According to Senate Public Employees and Retirement
Committee analysis, while the PERS Board Investment
Committee will decide how much of PERS' "contingent
liability" it will allocate to this program, the pension
fund rating agencies generally deem as prudent five-10
percent of total market value of assets (or $7-15 billion).
PERS staff suggests that a two percent allocation (or
approximately $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, PERS staff has
consulted widely, drawing from a financial institution's
25-year history of providing credit enhancement of
municipal bonds. As a result, PERS staff believes that
credit enhancement fees should be sufficient to provide net
returns to PERS of 40 basis points per annum. The chart
below demonstrates the projected gross fee income and PERS'
outstanding commitments for CEP.
Year 1 Year 2 Year 3
Total PERS' CEP Portfolio $1.0 Bil $2.0 Bil $3.0 Bil
($ Billion)
Minimum Projected Fee $4.0 Mil $8.0 Mil $12.0 Mil
Income ($ Million)
Initially, annual business expenses of approximately
$75,000 are contemplated for limited due diligence travel
and yearly rating agency surveillance fees.
Comments
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STRS already has a credit enhancement program
The State Teachers Retirement System (STRS) has been
engaged in a successful credit enhancement program for at
least 10 years, approved in legislation many years ago.
STRS indicates that a set percentage of the approximately
$113 Billion STRS Fund portfolio, determined by the
Teachers' Retirement Board, is used to back the bonds or
notes of public entities which employ STRS members. Income
from this program goes into the corpus of the STRS Fund.
One of the new programs PERS Fixed Income staff has
proposed under the 2002-03 Annual Plan is to establish a
CEP. PERS staff has been exploring program options to
provide credit enhancement to support infrastructure
development throughout the United States (U.S.), including
the feasibility of working with a Strategic Partner/Third
Party provider willing to participate in every transaction
with PERS 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.
What is credit enhancement ?
The primary objective of 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. CEP will be an off-balance
sheet component of the Investment Portfolio, enabling PERS
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.
As noted above, 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 (PERS) 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
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letter-of-credit (LOC). 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 (LE)." LE is used for short-term or variable
rate securities to give investors confidence in the amount
of liquidity associated with a specific security. Most LEs
contain a lesser degree of credit exposure than LOCs.
The following types of LOCs are utilized:
1. Direct Pay Letter-of-Credit: For this LOC, the investor
(through the Trustee) looks to the Direct Pay LOC Bank
(could be PERS) 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 PERS (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 PERS to make the payment. PERS
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 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, PERS 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).
FISCAL EFFECT : Appropriation: No Fiscal Com.: No
Local: No
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SUPPORT : (Verified 6/23/04)
Public Employees Retirement System (source)
ASSEMBLY FLOOR :
AYES: Aghazarian, Bates, Benoit, Berg, Bermudez, Bogh,
Calderon, Campbell, Canciamilla, Chan, Chavez, Chu,
Cogdill, Cohn, Corbett, Correa, Cox, Daucher, Diaz,
Dutra, Dutton, Dymally, Firebaugh, Frommer, Garcia,
Goldberg, Hancock, Harman, Jerome Horton, Shirley Horton,
Houston, Keene, Kehoe, Koretz, La Malfa, La Suer, Laird,
Leno, Leslie, Levine, Lieber, Liu, Longville, Lowenthal,
Maddox, Maldonado, Matthews, Maze, McCarthy, Montanez,
Mountjoy, Nakanishi, Nakano, Nation, Negrete McLeod,
Oropeza, Pacheco, Parra, Pavley, Plescia, Reyes, Richman,
Ridley-Thomas, Runner, Salinas, Samuelian, Simitian,
Spitzer, Steinberg, Strickland, Vargas, Wesson, Wiggins,
Wolk, Wyland, Yee, Nunez
NOES: Haynes
NO VOTE RECORDED: Jackson, Mullin
TSM:sl 6/23/04 Senate Floor Analyses
SUPPORT/OPPOSITION: SEE ABOVE
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