State of affairs compounds the woe

Government bail-outs fail to contain municipal deficits as states are obliged to commit huge chunks of their budgets to public sector pensions. A change in the law may ameliorate the fiscal turmoil.

Bring out the begging bowls

How about some cheery news? Since every state except Vermont must balance its budget by law, 49 of them have closed $430 billion (£276 billion) in shortfalls for 2009-11, by paring public services to a minimum, gimmicking their reserves and borrowing from the federal government.

Ah, if only life were so simple. Come this spring, many states will have exhausted the roughly $217 billion (depending how you slice it) in stimulus money that Washington kindly provided. Of that money, only $60 billion remains, leaving just $6 billion for 2012. Do not be numbed by the parade of billions. It does not even matter whether the numbers are precise, since the states have been raiding the cookie jar, playing games with the reserves they had built in good times. “The transparency in the budgets is atrocious,” says Lynn Turner, formerly the chief accountant at the Securities and Exchange Commission.

Among possible solutions to address the unsustainable shortfalls, “some are ugly and some are worse,” says Patrick Daugherty, a partner at Foley & Lardner, a law firm. The ugly sisters consist of slashing spending and raising taxes. Many draconian cuts have already been implemented, ranging from libraries, parks and old people’s centres to road maintenance; raising taxes is all the more challenging as property values have declined, reducing that source of tax revenue.

The most likely endgame – calling it a “solution” is a misnomer – is another trillion dollar local bail-out from Congress. The magnitude of payments will grow larger and faster, with compounding. “American society is a glutinous pig, overloaded with credit card debt. Just as people want to borrow personally, they also want their states to borrow,” Turner laments. He notes that many in the South and West will not be eager to belly up for another bail-out, which would aggravate their deep-rooted suspicions of coastal Californians and New Yorkers. (Many northern Europeans nurture similar feelings about perceived extravagance in the peripheral olive belt, which includes Portugal and Spain.)

The bail-out will probably ensue, however, because spendthrift states outnumber and outpower the prudent ones. North Dakota, the only state still solvent, lacks political influence, and “is an example of how the least powerful get exploited,” says Daugherty. Alaska and Arkansas, which do not project fiscal gaps for 2011, carry faint voices. A handout would encourage moral hazard and continued profligate behaviour, leading to wider fiscal chasms. But a bail-out will loom, as pressure intensifies. Remember how the government bailed out the auto industry in 2009, under a law that had been strictly intended for banks. (article continues below)

Over a barrel
The price of credit default swaps (CDSs) for cities and states has been widening in recent months. The cost of Illinois’ CDS swap insurance has climbed 16% since last July, overtaking even California’s, which is the worst rated state. A danger of writing “naked” (uncovered) swaps is that if a large investor cannot pay off its obligations, it may cause a ripple effect on all those holding the naked instruments. That could potentially shut down the $2.8 trillion municipal bond market, in the same way auction rate securities and asset-based residential markets dried up two years ago.

If states can no longer borrow to meet liquidity needs, firms become hesitant to do business with states. “The cyclone sucks everyone in,” says Turner. Imagine the social costs, too, down the road. For example, the education system would suffer as it becomes increasingly hard to attract teachers, not to mention firefighters or police forces.

There were only 54 municipal defaults from 1970-2009, with only four from cities and counties. In the short run, Daugherty expects at least a couple of high-profile defaults from cities, rather than states in 2011. Those blow-ups will drive municipal bond yields high, and depress prices across the board. A municipal bond sell-off would have a nasty significance, as those securities, considered exceptionally safe, are widely held by banks and by small investors in retirement savings. Serious rumblings in that market may be the event that triggers the next bail-out.

The bankruptcy option
It is no coincidence that the states with the most powerful unions, like California, are the worst fiscal offenders. Funds for union retirees’ pensions and healthcare are consuming the lion’s share of state coffers, “leaving no money to finance infrastructure or build roads,” says Daugherty. Professors Robert Novy-Marx and Joshua Rauh have calculated the present value of state pension liabilities for government workers, writing, “as of June 2009 we estimate that states had $1.89 trillion in assets set aside in pension funds dedicated to meet these obligations.” The authors arrive at a gap of $2.54 trillion under Treasury discounting. (Again, apologies for blinding numbers. Discounting assumptions play havoc with them anyhow.)

Major cities also face daunting shortfalls. In Chicago, $22 billion in the kitty must cover $66 billion in pension obligations to city employees, in New York City, $93 billion for $215 billion in promises, and in Boston, $3.5 billion for $11 billion, according to the Heritage Foundation, a conservative think tank.

By law, states cannot declare bankruptcy, although cities have been allowed to, since the Great Depression. The state prohibition derives from an American constitutional issue of federalism, which gives the states authority to run their own affairs. States cannot be forced to raise taxes, or be compelled to sell off their assets. The threat of liquidation prompts corporate bondholders to sharpen their pencils, realising that a firesale will bring them only a fraction of what they are owed. If, however, Congress enacted a new law allowing for voluntary state bankruptcies, that legislation might finesse the Constitutional impasse.

State bankruptcies would take some pressure off governors to confront public unions to renegotiate contracts, as well as haircuts for bondholders. It may be necessary to extend maturities or cut principal – a scenario many expect in the European olive belt. In America, it is the loose confederacy arrangement that has allowed these fiscal problems to develop, which a stronger central government might contain. Daugherty notes, “The experience on both sides of the Atlantic may be instructive.”