Southern California Real Estate Bubble Crash Blog

One of the most powerful experiences that investment bubbles can teach us collectively is how conservative we should  be when burned multiple times.  Unfortunately, for many of those newly exiting business schools or unaffected by a downturn show an uncanny ability to ignore others’ experiences.  The most powerful lessons of this past “lost decade” in the US (if we will but open our eyes to learn it) is that outsized returns cannot be depended on, and that risk does not equal reward, it just means risk.

CALPERS, the California Public Retirement Pension fund is about to learn that lesson the hard way. Formed in the 30′s, but built on the back of the 50s through the 80′s, it’s investment options expanded from solely bonds to real estate, to equities.  During this time, America experienced the greatest growth of real estate, equity, and bond values.  But most of all, of leverage.  Sadly, most of the value “growth” in the US over the past 20 or so years has been attributed directly to monetary growth.  Indeed, as yields on lower risk returns shrink, perception of higher risk equity values go up.  Unfortunately, for many, this mirage has much more power, and this perception that trees grow to the sky and all charts go up and to the right meant that there was little risk in promising free healthcare and pensions to the moon for all who worked for the grand state of California.

Except that it can’t.  The high profile failure of CALPERS has been nothing short of stunning.  Having lost more than 30% of its total value in 2008, it is unclear how the future promises made to state employees can be filled.  Especially when those promises are built on expectations that returns are 7.75% over the long run.

SFGate recently reported that they are considering lowering their benchmark rate above.  As reported:

Larry Fink, CEO of the giant money management firm, BlackRock Inc., with which CalPERS has invested, told its board in July, “You’ll be lucky to get 6 percent on your portfolios, maybe 5 percent.”

Even that might be optimistic.  When mortgages were returning 10% and you could expect a 1% chargeoff ratio and a 1% management fee, you could maybe meet the goal with a moderate amount of leverage.  When mortgages are yielding sub 5% and chargeoffs and management fees eat up most of that, you’d have to create an insane amount of leverage, which only increases your risk, to make it even rationally feasible, if even possible.

Why is this important?  Well, the benchmark rate determines the contribution rates, both of members and the State Government.  This is only one of many elephants in the room in California that noone wants to talk about it.  At precisely the time when the state can least afford to spend even more money, it may be required to.  Which only makes the situation more dire.  State and local government employees in California (in many, but not all cases) already enjoy higher pay than their private enterprise counterparts.  In addition to that, they are afforded better health benefits, vacation packages, and generous pay packages and benefits upon retirement.  When the world has all but forgotten pensions, many state employees enjoy the grandaddy of them all, a defined benefit pension plan.

It even seems quaint to talk about it since few still understand the difference between the defined benefit and defined contribution pensions.  It will suffice to say that the defined benefit is almost always much, much better, and much, much more expensive.  It’s quaint because most people who are not state employees in California do not even have a significant 401K, much less a crappy pension.  This is nothing compared to the Cadillac pension plan that virtually ALL state employees get.

So, to sum it up, California faces a budget shortfall of epic proportions.  It has parlayed every non-GAAP accounting trick in the book to delay the day of reckoning, hoping that pink ponies save them, but they have not.  The bill is quickly coming due, and indeed, the state may have even more troubles.  There is no way out.  Without serious pension reform (hand their asses back to them), taxes will have to be raised.  Given that the state already recalled one governor over licensing fees, I see this one going over like a lead balloon.  Meg Whitman has been campaigning that she can fix this mess.  I’m sorry, but there is nothing that will fix that mess except for a miracle or much higher taxes.  This still will need to invent something seriously out of this world to make that happen, or bite down on the bullet of austerity to balance the budget and maybe put something away for a rainy day (if it gets any rainier, this place is going to figuratively float away).

We need another investment bubble.  Luckily, the goldrush of 1849 proves that there is significant gold in them thar hills.  Perhaps we can put a tax on pickaxes and heavy machinery that will help us cover some of the shortfall.  With the bubbly prices that gold is now fetching, it might just do the trick.  However, I wouldn’t expect the Marijuana tax proposed earlier to make a big dent.  We’d need some serious potheads to move here to make it work (and they’d have to be stinkin’ rich to boot).

No, perhaps we we all need to collectively do as Californian’s is to do what CALPERS will in the end be forced to do.  Lower our expectations.  But, when have you ever known Californians to do that?