Are Municipal Bankruptcies Imminent?
State and local debt is at an all time high -- governments have borrowed $2.4 trillion as of mid-2010.
Are localities close to declaring bankruptcy or defaulting on loans? If they're not, why are so many in the media suggesting they are?
You can read about the imminence of municipal bankruptcies everywhere -- from the Wall Street Journal, where columnist David Wessel took note of "predictions that the next phase of the financial crisis will be a tsunami of municipal bankruptcies and defaults," to local news media and bloggers. Wessel ended his column by saying bankruptcies and massive defaults were highly unlikely. But stories continue to circulate.
Such talk costs states and localities. Fearful investors may demand higher interest rates from municipal bond issuers -- despite high credit ratings. A recent Wall Street Journal story noted that triple-A rated Utah paid a higher interest rate for a taxable Build America Bond than Microsoft did for a corporate borrowing. After calling for better muni disclosure, the story then noted, "the standard pitch about ultralow historical default rates among munis bears an eerie similarity to precrisis assurances that home prices never fall."
Where is all this tension about municipal bankruptcy and muni bond defaults coming from, and why? It's true that state and local debt is at an all time high. State and local governments have borrowed $2.4 trillion as of mid-2010, according to the Federal Reserve. That's an increase of 35 percent in the past five years. It's also true that several European countries, such as Greece and Ireland, have been on the verge of defaulting on their loans. Does that mean it can happen here?
Those are some of the issues I talked about with Robert A. Kurtter, managing director for public finance at Moody's, the credit rating agency. Here are some of the points he made:
Rising concerns: We have been experiencing the most serious recession since the Great Depression. Economists who are the keepers of business-cycle data have concluded that the recession ended in June 2009, 15 months ago. Clearly, state and local governments survived the recession without any great incidence of default. Now, we are into recovery and frankly, recovery for state and local governments is as difficult and painful as the recession was. The economic pressures on state and local governments continue to grow. Revenue growth has been very weak. The recovery is anemic, and there hasn't been as big a bounce back as we have had in business cycles since the 1980s. With recovery remaining weak, pressures on state and local government continues to be high profile.
Acting on fiscal problems: There are only three ways a state can address these problems. One is to cut spending, and we have seen a lot of that, including governments cutting programs long considered sacred cows. In K-12 education, where states do the largest spending, we are seeing reductions in state aid and local spending, resulting in teacher layoffs, reduced program offerings and elimination of extracurricular activities. The second way is revenue raising, and we have seen, despite anti-tax sentiment, state and local governments raising taxes -- mostly sin taxes and fees but there has been revenue raising. The third way is gimmicks, or ways of pushing problems off to the future -- delaying and deferring spending, not making contributions to retirement systems and deficit financing. We've seen state and local governments doing a lot of this and more.
Loose talk: Because these decisions are so difficult and painful, they become the topic of media attention. The rhetoric gets inflamed, and sometimes deliberately so as to catalyze government officials to make difficult decisions. Often verbiage is thrown around that is used colloquially and not in a legal sense. There may be talk about governments being bankrupt and insolvent when what is meant is, "We don't want to raise taxes and don't want to spend so we have to cut."
Stats on default: We're a rating agency so when we talk about default rates, we're only talking about rated credits. The rated universe is different than the entire universe; it's self-selecting and has stronger credits. The unrated market has more defaults and more risky securities.
That said, if you look back at the past three years, we had two defaults in 2008 and one in 2010. That's more than we've had in the past 39 years. But, with 15,000 ratings, the default rate is still extremely low. We expect defaults at a higher rate in this business cycle than historically because the recession went on so long and was so deep. We still expect muni defaults to be rare and idiocyncratic, usually the result of some other activity or competitive enterprise, such as an incinerator or steam plant that went bad.
Lessons from Vallejo's bankruptcy: Vallejo resorted to bankruptcy to renege on collective bargaining contracts it found unaffordable. That was 2007. At the time, the credit crisis and economic downturn were already in full swing. It was widely viewed that Vallejo heralded the beginning of a wave that would sweep across the country, and bankruptcy would become the tool of choice for governments looking to solve economic and financial problems. Three years later that has not been the case. Municipal bankruptcy is expensive, it's time consuming and the outcome is not at all clear. The locality doesn't necessarily benefit from it. And of course, the longer-term market penalty for reorganizing your debt under municipal bankruptcy is likely to be severe.
I don't expect municipal bankruptcies to become widespread. Even in extreme cases like Jefferson County, Ala., where they have already defaulted on debt and been in court over it, they've done everything except make such a declaration. Harrisburg, Pa., is having the same kind of debate. They are seeking refuge in the state's oversight program for distressed cities. So I would say, bankruptcy is discussed more than it's used. It's an expensive tool; it's an uncertain tool; and it's a very slow tool. Governments understand they need to figure out how to balance budgets and deliver essential public services now.
Worldwide debtors: Debt has been growing for state and local governments for a number of years now. But as a broad categorization, states and localities are generally not heavily indebted -- not relative to sovereign and sub-sovereign states around the world or to private corporations. State and local government debt is mostly affordable and not a large share of their overall budget. Some of the rise in debt more recently has simply been because interest rates are so low that debt is quite affordable.
For the most part, states and localities use debt differently than sovereign and sub-sovereign states around the world. Here, municipal debt is used for bricks and mortar -- to build bridges, roads, schools, parks, prisons and the like. It is mostly self-amortizing debt too, like a fixed-rate mortgage. Sovereign countries around the world don't usually have special capital budgets. They don't pay off the debt; they only pay the interest. So periodically, a country like Greece, Portugal or Ireland has large maturities it needs to roll over and refinance. If those large maturities happen to come due when the entity is stressed and the credit markets are weak, they can have problems that lead to massive default. That is not the case in the U.S. If credit markets closed, governments would slow down construction of roads and schools, but that would not result in massive defaults.
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