This week, Neighborly is interviewing Paul Rosenstiel, board member of the California State Teachers’ Retirement System (CalSTRS). Previously, Paul served as managing director at Stifel and managing partner of the San Francisco office of De La Rosa & Co.. From 2007-2009, Paul served as Deputy State Treasurer to Bill Lockyer in California.
Paul helped manage the State of California’s issuance of bonds during a national financial crisis. This proved to be a challenging time – one that offered learning experiences that Neighborly wanted to hear all about!

What does a Deputy State Treasurer do? How did you first get involved on this side of public finance?

After more than 20 years as a public finance banker, I joined Steve Westly’s campaign for governor in 2006 as his policy director. After Steve lost in the primary, I joined Bill Lockyer’s campaign team. When he was elected State Treasurer, he appointed me as one of his Deputy Treasurers.

One of my primary responsibilities was the issuance of bonds. The Treasurer issues almost all of the State’s debt. At the same time that Bill was elected Treasurer in 2006, the voters approved $46 billion of general obligation bonds. So, I expected issuing those bonds would be my main focus. However, things got more complicated than that.

What were some of the most memorable initiatives you worked on during your term?

We addressed the question of fairness around municipal bond credit ratings. In Lockyer’s opinion, the big three rating agencies – Standard & Poor’s, Moody’s, and Fitch – weren’t applying the same evaluation criteria to municipal bonds as they were to corporate bonds. Essentially, the agencies were holding municipal bonds to a higher standard even though their own statistics showed that municipal bonds posed a much lower risk of default. Lockyer and more than a dozen other major issuers wrote a joint letter to the three agencies asking that they implement a global rating scale. This began a national discussion that culminated in the Dodd-Frank Act which mandated important regulatory changes.

Why was this an important issue?

Investors use ratings as a key factor in assessing the riskiness of a bond and therefore, the interest rate they should receive from owning it. Bonds with low ratings are presumably riskier investments that should pay higher interest rates. Therefore, taxpayers or ratepayers will have to pay more to repay those bonds. But traditional municipal bonds almost never default, meaning they carry very low risk. (For example, between 1970 and 2016, only 28 bond issues rated by Moody’s defaulted, excluding housing and healthcare bonds). Yet the State of California had a lower rating than Lehman Brothers immediately before Lehman went out of business!

Why are there are so many different ratings if bonds rarely default?

Ratings serve the needs of investors. Small distinctions in ratings (known as “granularity”) will shift bonds prices as the ratings fluctuate up and down. These shifts provide profit opportunities for those who trade bonds. However, most individual investors buy municipal bonds and hold them until maturity. These investors are concerned that bonds do not default. Since municipal bonds rarely default, the granularity of the rating system provides little, if any, value to individual investors.

What was the biggest surprise in the bond market during the financial crisis?

Issuers found that a lot of complex bond structures they hoped would serve as cost-saving tactics, didn’t work as expected. The aftermath of the financial crisis has been a simplification of the market back to plain vanilla structures.

What’s an example?

Perhaps the most instructive was synthetic fixed rate bonds.

How did they work?

An issuer would issue variable rate bonds backed by bond insurance and simultaneously enter into an interest rate swap. The issuer would pay a fixed interest rate to the swap counterparty and receive a variable rate in return. The variable rate was expected to offset what the issuer paid on the variable rate bonds, leaving the issuer with just the fixed swap payment. However, the bond insurers lost their ratings and the scheme unraveled. First, the variable rate the issuer paid on the bonds rose but the variable rate it received on the swap did not rise. Then, many issuers discovered they couldn’t convert to simple fixed rate bonds. While they could redeem their variable rate bonds anytime at no cost, their swaps typically gave them no such flexibility. Many issuers faced termination costs in the tens of millions of dollars or more. These issuers went out to achieve a small potential benefit but the result was that they’d issued noncallable bonds and exposed themselves to the credit risk of the bond insurers.

How did all this affect how the state and other issuers now manage their debt?

Fortunately, the State didn’t have any synthetic fixed rate debt. Generally, the market has gotten much simpler since the financial crisis. Issuers mostly issue traditional fixed rate bonds and preserve their ability to call the bonds in the future. With greater simplicity, issuers and investors both have a better understanding of what is being sold.

Bond insurers are also limiting their risks to municipal bonds. So if a bond insurer is experiencing a loss in another market (mortgages for example) this now won’t affect the municipal bond credit.

And how is the state doing today?

In the last six years, the state’s ratings have steadily improved. California is now rated: Aa3/AA-/A+. The “recalibration” some of the agencies implemented in response to Treasurer Lockyer’s initiative for rating reform was a part of this. Most, however, was the State’s improving economy and Governor Jerry Brown’s strong focus on paying off past budgetary debts and building financial reserves. The State is also issuing less debt for new projects. In the ten years since voters approved $46 billion of new bonds in the 2006 election, they’ve only approved an additional $18 billion.

Overall, the financial crisis, while challenging, brought to light some major and necessary changes in the finance industry and I think we have all improved because of it.