Bankruptcy Court Rulings Uncover Historic Government Securities Fraud

Since 2009 Barack Obama and his Party have created eight trillion dollars of public debt.  What most Americans and investors are not aware of is that another eight trillion of government debt was created over the past forty years, mostly by Democrats. This is the accumulated unfunded public pension and municipal bond debt.  And unlike the national debt, which is easily found and exists on government books, this second amount of debt is not widely known.  What is more unsettling is how this debt was created and how it impacts all Americans. 

Its origin has been revealed through the bankruptcy court hearings of Stockton, California; Detroit, Michigan; and the financial situation of Chicago, IL. 

As public spending increased and public sector pension debt mushroomed, these and other city governments were unable to keep up with public pension plan expenses.  One fix they attempted was to borrow money from investors by issuing municipal bonds.  But these bonds only created more debt.

Say a muni bond is purchased for ten thousand dollars.  The buyer of the bond usually receives an interest payment from the issuer twice a year.  If the bond is a ten-year bond, then after ten years the buyer gets paid back the entire ten thousand dollar price at termination.   The interest payments made twenty times during those ten years are the interest income.

But Chicago, Stockton and Detroit came to the point where they could no longer afford to make those biannual bond and termination payments. To get through this financial squeeze cities began using financial engineering to remake debt, also issuing muni bonds and other instruments.

As larger cities filed for bankruptcy, the Securities and Exchange Commission set out to review how muni bonds are regulated.  Their 2012 report1 is not only very unsettling but proves government-sponsored securities fraud.

Here’s how the SEC set up this national securities fraud scheme.  Ordinarily, bond investors need to have valid information from the issuer regarding three topics: 1) revenue flow, 2) financial liabilities, and 3) market value of assets.  It’s important to note while SEC regulations require private sector corporate bond issuers to accurately disclose this information, the SEC intentionally wrote different disclosure regulations regarding muni bonds.

For example, muni bond revenue flow disclosures allowed assumptions of an 8% return on investments, which haven’t been seen in reality in many years.  And future revenue flows are distorted through fuzzy revenue flow reporting methods. The GASB through rule 65 is now recommending changes to how future revenues2 are reported.   The biggest factor was that unfunded pension liabilities which now total over $4.6 trillion3 did not have to be reported. 

In plain terms, muni bond issuers were allowed to cook the books; exaggerate revenue flows, overvalue assets and paper over debt4 through financial engineering.  SEC Commissioner Gallagher stated on May 29, 2014:

“In the private sector the SEC would quickly bring fraud charges against a corporate issuer and its officers for playing such numbers games. And, we would also pursue and punish the so-called fiduciaries who recklessly seek yield to meet unrealistic accounting expectations.”

Commissioner Gallagher did not explain why the SEC treated the public sector differently. 

While there does not seem to be a data set that lists the most fraudulent muni bonds, it is true to say they were all issued under the same regulations, and all the cities so far filing for bankruptcy have issued muni bonds under these regulations. 

Recent SEC efforts to change these practices have met with pushback and been called “controversial.”

So muni bond buyers, 72% of whom are retail (individuals), did not, and still do not, know what they are getting into.

Even though muni bonds were sold through fraud, both bankruptcy court Federal Judges, Judge Klein in Stockton, CA and Judge Rhodes in Detroit, ruled that some muni bond investors would lose up to 90% of their original investments.  Instead of getting 100% of their original investment back at termination, the muni bondholders are only getting 10% back.  The public sector pensions were given preference and allowed to keep virtually all of their benefits.5

If an American investor heard of a nation that was issuing muni bonds with shady disclosure rules and stole 90% of investors’ principal they would think the nation was some Third World banana republic.  But these are U.S. cities under Democrats. 

Since 2003, Illinois has allowed a number of financial engineering tactics to be practiced with these muni bonds.  Chicago’s use of these tactics such as interest rate swaps are only now being revealed through forensic financial analyses as written by Culpepper.

These financial shenanigans have one thing in common with the 2008 mortgage meltdown: they were brought about because government regulators didn’t follow private sector rules.  And while the 2008 meltdown revealed how the federal government changed the mortgage rules, the muni bond fraud reveals that the SEC always had a different set of rules for muni bond issuers.

Remarkably, the SEC still has not significantly changed the rules.  The Dodd-Frank Bill still did not correct the liability disclosure issue, and only recommended that a “commission” possibly look at the topic.

U.S. unfunded pension plan and muni bond debt now totals over $8.3 trillion dollars. This is equal to the entire U.S. national debt in 2006.  This includes one million muni bonds valued at $3.76 trillion and $4.6 trillion of unfunded public pension debt.  This is larger than the $5.25 trillion of subprime home purchase and refinance originations enabled from by the GSE Act from 1997 to 2007 which lead up to the 2008 mortgage meltdown.7  By comparison, the combined GDPs of Germany and Japan, the third and fourth largest economies on earth, totaled $8.6 trillion in 2014. 

The SEC has hired only six people to chase down violators.  These six have gone after New Jersey and San Diego but ignored Chicago, which has the most unfunded pension and bond debt.  Illinois was charged with securities fraud in 2013 but no one was punished.

The reason the unfunded pension fund liabilities should be added to the muni bond debt is that they are financially linked.  Muni bonds enable and support public pension debt because muni bonds are both secured through and paid for by property taxes. Every week Chicago and the state of Illinois add tens of millions more of pension debt which creates a demand for more muni bonds and higher property taxes.  In Chicago property taxes only go to pay for public pensions and bond debt.  They do not go for city services, in spite of what politicians say. 

In fact each household in Chicago now “owes” the city and state $88,000 for their unfunded public pension debts.  In effect the city and state are using every household as collateral to finance their retirement fund borrowing -- without their knowledge or permission.

The Federal government used the SEC to intentionally reject private sector bond regulations in order to institutionalize bureaucratic growth, underwrite patronage job pensions and redistribute debt to future taxpayers. 


  4.    See numerous embedded links
  6. Note 1, Ibid.
  7. pp. 37, 38.
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