Most state and local government pensions are underfunded, some by tragic amounts. Again, take a look at Collum’s Year In Review to get a sense of the magnitude of the problem. I wrote about Minnesota’s part in this back in 2013. At that time, the state was projecting 8% annual returns were necessary for the pension fund to be 75% funded. Grading on a curve, Minnesota is far from the worst.

If you’re a pension fund—a conservative investment vehicle—and you need 8% returns (at least) but you can’t gamble on an over-inflated stock market, what do you do? According to Reynolds, you invest a significant portion of your portfolio into leveraged credit instruments. Let me walk you through this.

McDonalds wants to borrow money, but they are a bad credit risk. Who will loan them the money? A largely unregulated credit agency—it might be, for example, a collection of Florida cities pension funds’—would find that intriguing, especially if it could be packaged together with a diverse range of other borrowers to theoretically lower risk (the way packaging subprime loans together was once thought to lower risk because, hey, it’s not like the corporate market is all going to go bad simultaneously).

But there is so much demand for high-yielding bonds (the modern term for junk bonds), that their interest rate remains low, far below the 8% return needed. To make up that gap, that unregulated credit agency borrows money. They magnify their gains with leverage by turning one dollar of cash into four or five dollars of investment. If you’re interested in understanding this, I wrote a whole series in 2013 that explains it. The downside of this strategy is that magnifying gains also magnifies losses, so this only really works when the market is going up.

All this I kind of understood, but Reynolds added two key insights for me that I hadn’t considered. First, he suggests that after the Detroit bankruptcy and resulting pension haircut, unions—aware that their pensions weren’t beyond being looted—went to state legislatures and lobbied for increased contributions to shore up the funds. I saw this happen in Minnesota, but it didn’t occur to me that this would happen everywhere. According to Reynolds, cumulatively this has meant more than $130 billion per year going into the credit markets, being magnified with leverage, and then loaned out, with much of it going to junk bonds.

This answers the question of where companies are borrowing from. Interestingly, Collum asked this question in his section on corporate debt, so I’m not alone in being confused on this:

The 54 AAA-rated companies in the S&P before the crisis have been reduced to only two because of leverage. Many—myself included—believe that the corporate bond market will be Ground Zero of the next crisis. In case I haven’t said it enough times, we are in a rising rate environment: The fuse has been lit. Net leverage normalized to EBITDA (earnings before interest, taxes, depreciation, and amortization) has doubled in only a few years. Tighter banking regulations acted like Prohibition, opening the door to hooligans, hedge funds, and other non-bank grifters with their own leverage. There is a so-called shadow banking system that is so enormous, complex, and hidden from the light of day for us Philistines. Here’s a trick question: Who do they borrow from?

The answer: leveraged government pensions.

Second—and I knew this but I didn’t get where the cash came from—a lot of these companies, like McDonalds, are using that borrowed money to buy back their own stock. Last year was a record for stock buybacks. This year is supposed to be another. There is good reason for a company to buy back their own stock if the company is undervalued, but it’s really hard to make that case for any company. It’s more likely that corporate CEOs, compensated based on share prices going up, can borrow cheaply in the credit markets (where pensions have created insatiable demand for yield) and then buy back their shares, propping up their share price. Reynolds actually suggests that, beyond passive investment vehicles, this is the only real action in the market today.

In November of 2007, a bunch of Florida cities were invested in something called the Local Government Investment Pool. It was a way to still be in highly-rated cash assets, yet get a better return on the taxpayer’s money. To provide those returns, the Local Government Investment Pool bought AAA rated subprime mortgage-backed securities. You know how this goes:

Leanne Evans, treasurer of the Palm Beach County school district, said that late in October she received a memo from the board’s outside investment adviser, pointing out that the investment pool always seemed to beat its benchmark and suggesting that she look into how it was achieving above-par results month after month. Normally, higher returns can be achieved only by bearing higher risks, and Ms. Evans wanted the district’s short-term money in instruments that were virtually risk-free. When she made inquiries, she said, she learned that the fund held some commercial paper backed by subprime loans. “Truthfully, it was a relatively small percentage of the portfolio,” she said. “But it scared a lot of people, because local governments would never invest in that.”

A run on the bank ensued, and it took years for local governments to be made whole.

Reynolds believes there is more time left—potentially a lot more time left—in the stock bull market because the pension money is going to put a floor under losses for quite a few years. This seems crazy to me—zombie companies continuing to see their value go up, when they should fail and make way for better managed competitors. But the pension money is like a steady stream of gasoline for the financial fire. Reynolds does predict an eventual credit crisis—something akin to, though degrees of magnitude greater than, the 2008 financial crisis—although it’s impossible to predict a timetable.

It’s time again for the age-old adage that markets can stay irrational longer than you can stay solvent.