2011: The Bad Year That Wasn’t
In this Public Finance column, John E. Petersen says that despite dire forecasts, states and localities paid their debts on time and in full.
As 2012 dawns, state and local governments have many fiscal worries. Even so, they can celebrate something: 2011 failed to live up to the dire predictions of widespread defaults and bankruptcies.
There were problems aplenty. Local governments, dependent on revenues closely hitched to the housing market, saw their revenue sources wither with the housing bubble’s deflation. At the same time, the dark clouds of unfunded pension liabilities sat heavy on the horizon. It seemed possible that local governments might simply stop paying on their debt and mail the keys to city hall back to the bank.
Investors in the bond market may have been worried that a flood of defaults were, indeed, on the way -- especially after Meredith Whitney, a noted stock market picker, announced her forecast for mass defaults in 2011. They fled municipal bond funds, driving prices down and interest rates up, and threatening the muni market’s viability. But in the summer, investors sobered up, took a look at history and considered the facts at hand.
Distilled to its core, the Great Recession and its ongoing fallout isn’t the Great Depression of the 1930s. Even in the 1930s, the thousands of defaults of municipal bonds were caused not by local governments running out on their debts, but primarily by a failure of the banks that held their deposits. When the U.S. banking system was reconstituted in 1934, the flow of new defaults ceased and the existing ones were cured.
In the current troubled times, some defaults were already history by the end of 2010. But almost all of the $2.7 billion in municipal bond defaults that year involved nongovernmental purposes. That is, they were bonds tax-exempt under the federal tax code that were sold for private purpose activities, such as housing developments, and commercial, industrial or long-term health-care facilities. Such private purpose bonds, many of which are unrated, make up about 10 percent of all tax-exempt bond issues. Over the years, however, they have represented about 80 percent of the dollar volume of all the “municipal” defaults.
Some defaults have made big headlines lately, namely Harrisburg, Pa., and Jefferson County, Ala. While the Jefferson County bankruptcy filing at the end of 2011 was the largest ever municipal bankruptcy, it’s a singular story of corruption, incompetence and Alabama’s failure to step in with a restructuring plan. With Harrisburg and its failed incinerator financing, the state has contested the filing for bankruptcy and wants to put in a receiver to run the city’s finances. Since the bonds in both cases were insured, the insurance companies took the hit. Individual investors were largely unaffected.
The question remains: Why didn’t we see all the defaults predicted a year ago? The main reason is that most defaults in the tax-exempt market have little relationship to government’s financing of its own activities. When state and local governments collect taxes and fees, and spend on publicly owned and operated facilities, they have debt service requirements (paying interest and principal) that amount to a minor part of their annual outlays. Debt service payments equal only about 8.1 percent of state expenditures and 13.6 percent of local government outlays, including those of local utilities. Other safety margins are built in: To the extent that local governments finance capital projects from their current receipts, such spending can be reduced in bad times (like now) to ensure that funds are available for debt service.
Moreover, states and localities, with a few glaring exceptions, are by necessity fiscally responsible. They can’t finance their current operations with prolonged borrowing in the public markets. The credit rating agencies, as troubled as that industry might be by past mistakes, have acted as a gatekeeper on borrowing by state and local sectors.
Finally, the Great Recession hit states and localities with a delayed impact. Since they had a two-year buffer provided by the federal stimulus program to prepare for shrinkage, they implemented such adjustments as laying off employees and cutting programs to align with their diminished fortunes. While many may regret this “procyclical” behavior, it reflects the electorate’s “pro-austerity” mood and desire for less spending. Meanwhile, the municipal bond investors have been protected and the bond’s reputation for safety preserved.
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