How Real Is the Bankruptcy Threat?
State and local leaders have taken to saying, ‘We’re broke.’ The true story is a lot more complicated.
Revenue is falling. Demand for services is increasing. A trillion-dollar pension liability looms. No wonder there is speculation about the fiscal well-being of states and localities. In some circles, there’s a growing presumption that these financial woes will lead to a bevy of municipal bond defaults or even some big bankruptcies.
Is it true or just conjecture? That all depends on who is doing the talking.
By now, the claims of analyst Meredith Whitney -- who predicted on 60 Minutes last December that there would be 50 to 100 sizable municipal bond defaults -- are famous. Her predictions came just as federal stimulus money that helped states weather the recession was scheduled to end. States then started passing the fiscal pain down to localities by cutting aid to them. Meanwhile, localities had already been through several years of belt-tightening, with the worst yet to come: the likelihood that property taxes will decline next year and beyond that.
Headlines about these struggles, compounded by Whitney’s predictions, have spooked investors and caused a boatload of trouble for state and local governments hoping to raise money in the capital markets. When the press gets its teeth into a story like this, “it does have an impact on financial markets,” says Mike Belarmino, associate legislative director at the National Association of Counties. The result has been a 30 to 35 percent increase in the cost of borrowing for state and local governments since last summer. “Meredith Whitney cost us quite a bit of money,” says Washington state Treasurer James McIntire.
To an extent, state officials themselves may be contributing to the sense of impending disaster. Some state and local leaders, for instance, have pled poverty in the hopes of persuading Congress to restore lost federal aid. Others, working to advance their cost-cutting agendas, have created an atmosphere of fiscal crisis by repeating, “We’re broke.” Meanwhile, the media, seeking to advance the next big story, has furthered a narrative that municipal bonds are the next housing bubble. There has also been speculation that some investors capitalized on the situation by pushing a mass exodus from investment in municipal bonds.
Many storylines have, in fact, emerged around the question of municipal solvency, some of which threaten to be accepted as reality. Some stories are just that -- myths that aren’t backed by any solid facts. But in most cases, separating truth from fiction is much more complicated.
Myth 1: Meredith Whitney’s predictions were hopelessly wrong.
Nary can a conversation be had about municipal finance without Whitney’s forecast being mentioned (see "The Truth about Bankruptcy"). Most analysts in government and finance agree that, yes, she vastly overstated her case on 60 Minutes. Even she has backtracked somewhat since December. But the reality is, municipal defaults could reach much higher levels than the low-risk municipal market is used to. Given the pressures on state and local budgets and the announcement by Moody’s, the credit-rating agency, that there will continue to be more credit downgrades than upgrades this year, her pessimism isn’t misplaced.
She also raised valid concerns about which constituents states are ultimately beholden to -- taxpayers, bondholders or public employees. The three often have competing interests that can’t be easily reconciled. Even Whitney’s critics say her comments have helped put a much-needed spotlight on the fiscal issues states and localities are facing, particularly with underfunded pensions, unfunded health care for retirees and the rising costs of Medicaid. Forty-four states and the District of Columbia project budget shortfalls totaling $112 billion for fiscal 2012. This is not the first, second or even third year they’ve faced massive budget gaps. The situation is such that, Reid Smith, a portfolio manager with RBC Global Asset Management, has suggested that states and localities do a complete re-evaluation of how governments operate, what services they need to provide, and what means they use to pay for those services. “Decisions,” he says, “have to be made outside the box.”
As for Whitney’s specific predictions on defaults, critics counter her argument by noting the historically low rates of default in the muni market, (see "The Debt Demon"). While the market is not likely to face the sort of catastrophic scenario Whitney described, she is correct on at least one point, writes Greg Donaldson, director of portfolio strategy at Donaldson Capital Management, in a column on the Seeking Alpha business website. “[T]oday’s municipal bond market is not the sleepy, low-risk market that most of us have come to know and trust over the years.”
That said, when it comes to avoiding a default on a bond, states and localities have an inherent advantage over corporations: they can increase taxes or fees to raise money to pay their bondholders, or they can find the money by cutting services without losing income. Both tactics come, of course, at a high political cost, but even in a financially troubled state like Illinois, “its fundamentals are ultimately substantially better than an over-debted company,” says Phineas Baxandall, a senior tax and budget policy analyst with the advocacy group U.S. Public Interest Research Groups. Nonetheless, academics and industry analysts agree that while there is likely to be an increase in defaults, such events won’t reach the levels predicted by Whitney -- and they will be isolated events.
Myth 2: Bond debt and retiree benefits are crushing states.
Yes, the Great Recession has taken a tremendous toll on pension fund portfolios; states and localities have not jumped to make up the difference with tax revenue. And yes, states have taken advantage of low interest rates and federal subsidies on those rates to raise money for public projects. But commentators who see these as back-breaking costs for state and local purses have commingled the two issues, says Iris Lav, a senior adviser at the Center on Budget and Policy Priorities. And that, she suggests, makes the immediate future seem more dire than it really is. Municipal bond debt payments account for only 5 to 8 percent of state and local budgets, which is considered a reasonable level. Pensions are only 3 to 4 percent of state and local spending.
True, there are serious issues facing pensions: In 2008, most state pension plans were more than 80 percent funded, while last year, only about one-third of states funded them at that level. But the issue has not reached a crisis level in most states. Most plans can continue covering benefit payments for 15 to 20 years, and even in New Jersey -- which according to the Pew Center on the States has one of the highest levels of unfunded pension liabilities -- state pension assets covered 2009’s obligations tenfold. The majority of states are taking steps to address the stress facing their plans, such as cutting benefits for new employees, reducing cost-of-living adjustments and increasing employee contributions above the now typical 5 to 10 percent level. The problems are huge but not insoluble. States also have a big bill coming due on retiree health benefits. But those benefits don’t face the same legal protections as pensions, so they may lend themselves to a wider variety of solutions.
In a recent report, the Government Finance Officers Association noted that neither bond payments nor pension funding will cause default or bankruptcy. But that doesn’t mean governments can kick the can down the road. Governments need to act fast on pensions, since there is little room for error. Bond debt and pensions “are two distinct problems right now,” says Peter Hayes, head of the municipal bonds group at asset management firm BlackRock. “That distinction is beginning to narrow over time.”
Myth 3: State bankruptcy is a far-fetched notion.
The federal bankruptcy code allows municipalities to declare bankruptcy. It makes no such provision for states. Some congressional Republicans began speaking earlier this year about the possibility of creating a bankruptcy mechanism for states. The idea was to give states a way to get out of debt. But it also stemmed from a self-protective reflex: A bankruptcy provision for states could reduce the likelihood that the federal government would have to bail out a struggling state.
Advocates of a state bankruptcy provision say it could offer states some needed flexibility. For starters, a state might be able to alter the contracts of unionized employees and get more savings than they would through piecemeal changes outside of the bankruptcy process. They might also be able to alter some -- though not all -- aspects of retiree pensions.
Bankruptcy also might allow a state to reduce its bond debt, which is difficult to alter outside that process. By using the bankruptcy court to bring bondholders to the table, bankruptcy would ensure that employees and citizens aren’t alone in bearing the sacrifices of a state’s financial struggles.
Critics of allowing states to declare themselves bankrupt -- namely, governors -- have taken umbrage at the discussion of a state bankruptcy mechanism. They argue that they don’t need it and that such chatter spooks investors and increases borrowing costs.
To be sure, a declaration of bankruptcy would have serious implications in the financial markets. But, says David Skeel, a law professor at the University of Pennsylvania, it would beat a complete default. As to arguments that state bankruptcy would be unconstitutional due to its threat to state sovereignty, Skeel, who is one of the leading advocates for a state bankruptcy law, dismisses that notion. He suggests that it could easily be worked out by making the process voluntary, as it already is for municipalities.
Critics say state bankruptcy isn’t needed because states almost always find a way to make payments, even if it isn’t pretty. The last state default was Arkansas in 1933, and virtually nobody expects a state to default as a result of the current financial situation. So why bother? “It’s dangerous,” Skeel says, “to say that something that happens rarely is something that we can ignore.”
At the present time, House leadership has dismissed the notion.
Myth 4: Bankruptcy is a panacea for ailing municipalities.
In many states, localities can declare bankruptcy -- and a few have. But that’s not to say that those who’ve done it have found it to be an ideal option. To even consider bankruptcy, a locality would likely be facing extreme pressures from declining tax revenues and increasing demands for social services. But other factors are more likely to drive it to the brink of bankruptcy: mismanaged investments, poor oversight over the financing of an infrastructure project or unsustainable labor contracts.
The most recent example of a city working its way through a declaration of bankruptcy is Vallejo, Calif. It filed for relief from its creditors in 2008, and it is likely that a judge will approve its financial plan as early as next month. That plan involves restructuring some $50 million in publicly held securities. It also gave the city the opportunity to renegotiate contracts with city workers -- one of the main reasons the city declared bankruptcy -- which has already resulted in savings of $34 million through June 2010.
But bankruptcy has its challenges. In about half of the states, municipalities must first get permission from their legislatures to file for bankruptcy. That itself is an uphill battle. Furthermore, the market can punish a bankrupted municipality for years if creditors get stiffed, and bankruptcy can cause a stigma that hurts the area’s business climate. Then there’s the actual financial cost of bankruptcy attorneys, which can top seven figures for large entities. That’s a big sum for a service that does absolutely nothing to address the underlying financial problems facing a government. The bankruptcy in Vallejo could ultimately cost up to $10 million in attorney’s fees, says John Knox, a lawyer representing the city.
Bankruptcy is unlikely to help municipalities adjust their pension obligations -- until it’s too late. A municipality must be insolvent to get protection. “It’s not a balance sheet test that says your debts are bigger than your assets,” Knox says. “It’s a cash-flow test. If you look down the road and the actuary says the pension trust goes bankrupt in 10 years and has no money, that’s not going to get you into bankruptcy.”
Given bankruptcy’s limitations and downsides, few state and local officials expect to see a spate of municipal bankruptcies. Since 1980, there have been 250 municipal bankruptcies; only 46 of those were a city, village or county -- most were utilities or special districts.
So far this year, there’s been one major bankruptcy: Boise County, Idaho, and it shouldn’t be considered a harbinger of trouble to come. Its problems were caused almost entirely by one extraordinary event: A federal jury awarded a judgment against the county representing more than half its $9.4 million operating budget. Jefferson County, Ala., has been on the verge of bankruptcy also due to an extraordinary event: miscalculations in the financing of a new sewer system.
There’s another reason why it’s unlikely that many cities or counties will declare bankruptcy. For localities that get in trouble, there’s typically a backstop: the state. Whether it was New York in 1975 or Philadelphia in 1990, localities are often aided by a control board set up by the state to advise and helplocal leaders. Earlier this month, Michigan created a law that allows for earlier state intervention and greater authority of emergency financial managers when a municipality is spiraling out of fiscal control. New York state recently took steps to oversee Nassau County’s finances—over the objections of county officials. Financial analysts expect to see more of those actions rather than bankruptcies.
Myth 5: The municipal bond market is now an unsafe place for investors.
Last fall, investors started taking more money out of muni bond investments than they were putting in. In December alone, mutual funds pulled $12.9 billion from the municipal bond market.
For the most part, the bulk of the disinvestment has been by individual investors, who tend to hold the bonds through mutual funds. Less knowledgeable than institutional investors about the vagaries of the municipal bond market, they have been spooked by the headlines suggesting that states and localities are broke and can’t pay their bills.
They also may be uneasy over recent defaults -- 271 totaling $8 billion since July 2009. But those defaults, says Thomas Doe, CEO of Municipal Market Advisors, represent one-quarter of a percent of the market. Moreover, the defaults didn’t include any general-obligation bonds -- the kind that are backed by the full taxing authority of a municipality -- or revenue bonds that are backed by payments from an infrastructure project, such as road tolls or water fees. Instead, trouble has come from bonds “on the fringes” of municipal finance, such as housing and casino deals. “It’s important to carve out general-obligation debt and [other] tax-backed debt from the rest of the municipal market,” says Hayes of BlackRock.
Some commentators have compared the state of the municipal market to the pre-bubble mortgage market. But Lav, of the Center on Budget and Policy Priorities, says that’s not an apt description, since the quality of debt offered hasn’t deteriorated like it did with subprime mortgage bonds.
In fact, many seasoned Wall Street investors and analysts say they have seen nothing to change their minds that both state and local general-obligation debt is secure. “When we get beyond this [volatile time],” says John Dillon, chief municipal bond strategist at Morgan Stanley Smith Barney, “we’re going to see this market shouldn’t have been traded that way.”
Indeed, the situation has already started to improve. As of the end of the first quarter of 2011, the drain away from municipal bond investments had slowed -- but it had not stopped.