BILL ANALYSIS
SENATE PUBLIC EMPLOYMENT & RETIREMENT BILL NO: AB 2364
Nell Soto, Chair Hearing date: June 21, 2004
AB 2364 (Correa) as amended May 24, 2004 FISCAL: NO
STATE RETIREMENT SYSTEMS: CREDIT ENHANCEMENT PROGRAMS
HISTORY :
Sponsor: California Public Employees Retirement System
(PERS)
Prior legislation: None
ASSEMBLY VOTES :
PER & SS 7-2 5/5/04
Assembly Floor 77-1 5/26/04
SUMMARY :
Would authorize state pension systems to establish credit
enhancement programs to assist issuers of municipal and
public finance debt, as specified.
ANALYSIS :
1) 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.
2) This bill would authorize all state pension systems to
establish credit enhancement programs to assist issuers of
municipal and public finance debt, as specified.
The Committee is advised that 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 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)
David Felderstein
Date: June 16, 2004 Page 1
FISCAL EFFECT :
According to the sponsor (PERS), despite the risk associated
with any investment program that PERS administers, the PERS
Fund is expected to receive fee income from the credit
enhancement program (CEP). PERS has provided the following
information on fee generation.
David Felderstein
Date: June 16, 2004 Page 2
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 5-10% of total market value of assets (or $7-15
billion). PERS staff suggests that a 2% 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 Income $4.0 Mil $8.0 Mil $12.0 Mil
($ Million)
Initially, annual business expenses of approximately $75,000
are contemplated for limited due diligence travel and yearly
rating agency surveillance fees.
COMMENTS :
1) STRS already has a credit enhancement program
The Committee is advised that 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
David Felderstein
Date: June 16, 2004 Page 3
corpus of the STRS Fund.
2) Arguments in support
The Committee is advised that 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.
David Felderstein
Date: June 16, 2004 Page 4
3) 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
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:
a) 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).
David Felderstein
Date: June 16, 2004 Page 5
b) 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).
c) 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).
4) OPPOSITION :
None to date
David Felderstein
Date: June 16, 2004 Page 6
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David Felderstein
Date: June 16, 2004 Page 7