Posts Tagged ‘state and local politics’

The Grand Jury of San Diego issued a report of this title yesterday.  Also, at yesterday’s GFOA (Government Finance Officers Association) business meeting, the group voted  that the Government Accounting Standards Board should stay away from the topic of sustainability.  The only conclusion one can draw from the Grand Jury report is: the city of San Diego’s current trajectory is UNSUSTAINABLE.  Here, are a few choice passages (please read as if these too, were fully capitalized):

The City has yet to articulate structural solution to close the multi-million dollar budget deficit in fiscal year 2010.  More than 50% of this gap in financing was filled by using one-time solutions, such as skipping reserve payments and deferring projects.

In summary, this investigation is presented to the City and its citizens because the status quo is not going to resolve the crisis of financial instability, unbalanced budgets and reduction of the city’s obligations, liabilities and debts.

One of the underlying causes of the current structural budget imbalance is the underfunding of the City’s pension obligation by previous City administrations.

Ok, we know this.  This is true among states and municipalities across the country.  But what to do?  In some (not all) places the pitch of the problem has reached a scream – CONTINUING GOVERNMENT OPERATIONS ARE UNSUSTAINABLE.  Amazingly, the choice to cut critical services has become the lesser of two evils – the other being pension and benefit reform.  Elected officials, charged with managing cities like San Diego would rather have fewer cops, less trash pick-up, deteriorating infrastructure and higher taxes, than deal with runaway benefit spending.  Even if you believe that the benefits are deserved, earned and righteous, the city simply does not have the resources to pay these costs and also maintain a livable city.  So what’s the decision?  Give up the livable city?  The City’s Independent Budget Analyst stated:

Structural deficits require structural solutions.

The report suggests using the federal bankruptcy courts to determine what can and cannot be restructured.  Investors, along with public employee unions (strange bedfellows) hate this solution and prefer to stay in one-shot-land, or stand by while the deterioration mounts (see stories on Vallejo’s increasing crime.)  The courts could also decide to trim back debt obligations in the same restructuring process.  This has happened in Vallejo, where there is a moratorium on debt service payments (at least with the current intent of re-paying in full at the end of the moratorium period).  Vallejo’s bankruptcy tackled the city’s ability to reject union contracts, a key step, but they did not touch the pension issue.  The San Diego Grand Jury suggests a bankruptcy court could help sort out this benefits conundrum.

Finding 26: A proactive dialogue as to the efficacy of a Chapter 9 reorganization cannot be removed from any discourse as to the City’s financial health

Finding 27:  A Chapter 9 filing would result in a federal determination of which fringe benefits and collective bargaining agreements could be restructured.  The fringe benefit total is $423.7 million, according to the FY 2011 Proposed Budget.

RECOMMENDATION

The 2009/2010 San Diego County Grand Jury recommends that the Mayor of the City of San Diego and the San Diego City Council:Convene a panel of bankruptcy experts to discuss the legal and financial ramifications of a Chapter 9 declaration of bankruptcy, in the context of a publicly noticed City Council or Council Committee meeting. 

In this context, the municipal credit analyst, the investor and the taxpayer, need a new tack on fiscal review.  Unfunded pension liabilities must be included as a long term debt in debt ratios.  The rating agencies discuss these burdens but they are not included in the numbers. Medians that include all long term and contractually obligated costs should be developed to correctly compare cities and identify outliers like San Diego Vallejo.  The long term cost of these obligations should clearly be disclosed so that ratios may be calculated.  For example, red flags of fiscal trouble are waving fervently in San Diego’s case and the Grand Jury mentions Vallejo as well:

In 1994, the city’s budget for pension expense was 6% of payroll cost.  Today, sixteen years later, the cost is 28% of payroll, and growing.

For FY2009, the City’s fringe benefits rate was 52.5% of budgeted salaries of $728 million (IBA Report #09-10 issued February 24, 2009, p.2).  On average, privately operated companies spend 35% of budgeted salaries on fringe benefits. 

Some 76% of Vallejo’s operating budget went to salaries and benefits.  The norm is 50%.  Pensions were not an immediate issue since Vallejo had funded its pension obligation.  Vallejo’s most significant liability was $135 million of unfunded health care.  Vallejo officials brought the unions back to the bargaining table after the federal bankruptcy judge ruled collective bargaining agreements can be voided. 

A few other red flags that can be identified with a bit of extra work:

Is the municipality/state postponing annually required benefit contributions?  Is the government making its “annually required contribution” or ARC?  If not, this will catch up quickly as evidenced in San Diego (see separate post on the state of Illinois)

Are judgments and claims high and increasing?  This points to the government’s poor risk management practices and sloppiness.  This is a low-hanging fruit that cities should tackle with gusto.  The Grand Jury found in San Diego’s case:

Funding of the City’s (self-insured) public liability fund against lawsuits that could drain the General Fund for years to come.  As of June 30, 2009, the City faces $129 million in claims.

Funding the city (self-insured) worker’s compensation fund against outstanding claims, currently estimated at $161 million.

As the press and blogosphere keep telling us, there will be more municipal defaults and bankruptcies.  But there is a difference between painting all securities with the same brush and rigorous analysis.  We believe the flags are identifiable. 

We are coming out of a period when investors bought municipal bonds with their eyes closed.  The mantra that municipals don’t default and the once widespread presence of bond insurance convinced the investing community that analysis was irrelevant.  No more.  On the other hand, Congress has pressured newly contrite rating agencies to upgrade municipals at perhaps the worst time in history. 

San Diego’s GO ratings?  Moody’s: Aa3; Fitch: AA- and Standard and Poor’s: A 

There is a table at the end of the Grand Jury report with a September 6, 2010 deadline for city officials to respond to the specific recommendations.  The Mayor, the City Council, the Retirement System’s administration, the Audit Committee and Independent Auditor are required under the state of California Penal Code to do so. Looks like a busy summer.

The Illinois Comptroller’s April report  is scary reading.  The state is $4.5 billion in arrears on payments to vendors and others (like school districts and service providers) with no end in sight.  The Comptroller expects 2011 to be worse.  The following chart from the report looks to me like a deteriorating structural imbalance moving towards a delicate liquidity position.   

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As long as markets are willing to provide liquidity, the state will be able to continue on this trajectory.  As we learned from the New York City fiscal crisis in the mid 1970’s, not to mention the banking liquidity issues beginning August 2007 and later, those institutions that depend on short term market access for viability will freeze up (seize up?) when the markets don’t cooperate.  

The Civic Federation prepared a detailed analysis  and critique of the proposed 2011 budget.  In the report they graphically present the state’s roll-over of short term debt from 2009 to 2010.   In 2011 the state expects to issue $4.7 billion notes for “voucher payments.”  Where will the re-payments come from?  

So here’s some simple math.  The state’s debt service payments for 2011 jump from $1.6 billion to $2.8 billion.  Short term debt will be $4.7 billion.  The budget assumes $27.4 billion General Fund revenues in 2011, so it looks to me like debt service consumes a hefty 27.4% of that total.  Red flag.  Maybe there will be some roll-overs, some additional budget cuts, maybe some tax increases, maybe the economy will be good to the state and they will make it into 2012.  But the long-term problem here is huge.  

 Bondholders are feeling sanguine since, like California, payments go to debt service before other services.  As tax increases loom on the horizon, investors want that tax exempt paper.  As the Civic Federation described:  

As the State continues to issue more G.O. debt than it retires on an annual basis, the amount of General Funds committed to debt service payments will continue to rise. To make these payments the State pledges its full faith and credit to its bondholders and legally commits itself to transfer the debt service payment into the General Obligation Bond Retirement and Interest Fund (GOBRI) prior to paying any other bills or transferring funds for any other appropriations.

  

  

 

  
 
 

 

I’m putting on my public policy hat now (as opposed to financial analyst).  There’s no mechanism for bankruptcy or receivership at the state level in the U.S. which may be comforting from an investor’s perspective, but lousy public policy.   There’s no IMF and no process at the federal level to re-structure state finances other than handing out bailout grants or loans — which usually require increased borrowing or matching spending.   There’s no Board of Directors as in the private sector whose charge is to protect shareholders (substitute “taxpayers” for shareholders) even when painful actions are necessary.   So we are left with random taxpayer uprisings and the occasional vote for elected officials and the analysis of think tanks.  Maybe there will be a lawsuit by vendors or school districts to get the state to meet its obligations.  Maybe vendors and residents will vote with their feet.   The preferred approach would be an objective mechanism with authority and mettle to resolve the fiscal mess.   Someone please tell me that I am wrong …

Tight financial margins are not kind to political squabbles.  In the last few weeks the city of Los Angeles has been engaged in a squabble with the city council and its utility, the Los Angeles Department of Water and Power (LADWP).  The city’s mayor wants the utility to implement green power, the utility asked for a rate increase to cover additional expenses, the council refused and the utility held hostage a transfer to the city of funds.

Each of these events has its own logic, but when the “b”-word (as in “bankruptcy”) got thrown around, the city’s rating was downgraded and put on negative watch. 

Looked at from a different perspective, when one body of government promotes green power or makes a regulatory change, utilities either get some kind of financial incentive or are simply required to comply.  They could file a rate increase request with their state Public Utilities Commission.  Or at the municipal level the utility would pass along the extra costs to the consumer – assuming the local council goes along.  The PUC could grant the increase (or not) and the utility would charge higher rates or alternatively eat the loss through lower profits (or maybe find savings!).

Transfers from municipally owned utilities are also common practice.  Think of them as “payments in lieu of taxes” (PILOT).  Most investor owned utilities (IOU’s) pay taxes to the local government.  The PILOT or tax covers the cost of the usual stuff – police, fire, sanitation, roads that benefit the utility, as well as an economic environment that allows the utility to grow or maintain its customer base.  In some parts of the country, where municipally owned utilities are more common, these transfers are made below the line – after all other expenses have been paid – so that the security covering utility bonds is not compromised.  For IOU’s, not paying the corporate taxes – is out of the question.  Non-payment could result in penalties or shut-off of power.

Not so in Los Angeles where all of this is up for negotiation.  In tight economic times, when reserves are thin and maintaining monthly cash flow is essential to the government function, a hold-up could spell disaster.  The LA city council opted to play a high stakes game and in the current environment, the mayor’s counter-offer of bankruptcy or shutting down city government added fuel to the fire.  Factors that are not up for negotiation elsewhere got caught in the political crossfire in Los Angeles.

I am posting Municipal Utility Transfers , an article I wrote  some time ago on this topic – covering Los Angeles under Mayor Riordan – that still has merit today. For municipal history buffs (a small and nerdy group), today bears a strong resemblance to the 1992 period: a run-up in asset values followed by a bubble-burst; taxpayer protests; downgrades and economic recession, particularly in southern California not to mention the Clinton mid-term elections.  Keep in mind that the city of Los Angeles and its utility are large, diverse and wealthy and will be able to manage through the storm.

We have two opposing camps in the muni-market at the moment: those who say it is the next systemic shoe to drop and the rating agencies that are systemically raising ratings.

Which is right?

We have moved from a market that has had heavy intermediation from the bond insurance companies to one where investors are on their own. Bond insurers historically performed heavy analysis and monitoring of the credits they insure and actively affect the legal protections embedded in a security. Bank credit enhancers have done the same, although in some cases their agreements allow them out of the risk under certain circumstances. Rating agencies assign their rating on sale and their business model has never been designed to provide robust monitoring of issuers in the secondary market. The Moodys and other agency default studies covered this time period – a relatively prosperous period from 1970 – 2007 when pending defaults on the investment grade level were mostly managed by bond insurers. Further, the default studies did not include insured bonds.

Municipal bonds do default and have throughout this period –not at all in large numbers by any comparison to the corporate world. Knowledgeable high yield investors are aware the risks in hospital, senior care, land development, and corporate-style tax exempts such as industrial revenue bonds. Project finance, such as the Harrisburg incinerator, Las Vegas monorail and Connector 2000 also carry high risk. (I should add WPPSS and other nuclear power projects to this list.)  These should not be lumped together with the other 30,000 or so municipal bond issuers. Like the stock market, there are many, many nuances among borrowers. Only now the investor is left to grapple with his own resources – and the loss of granularity among this diverse and deep market from ratings “re-calibration”.

(Concerning re-calibration of ratings:  As I have said before, lowering corporate ratings to their appropriate probability of default relative to municipals – would achieve the same effect, and be truer to their own research. Instead, the agencies are compressing ratings into fewer categories and eliminating much granularity for investors. But of course the other approach would have been business suicide and harmed many corporate portfolios.)

Within this, market prophets are now generalizing greatly, mostly those who have not spent their careers in this non-standard, messy, sometimes corrupt and poorly understood state and local financial world.

This brings me to some comments on Rick Bookstaber’s recent post. Many of his points are strong and need to be actively debated, but others generalize to the detriment of this very varied marketplace.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Agreed. The Tower Amendment should be abolished and municipalities that want to participate in public capital markets and be rated like corporates should be held to the same reporting standard. Period. Would you buy a corporate bond whose disclosure was two years old?

The argument that it’s too expensive and too burdensome for smaller municipalities to achieve transparency can and must be resolved. Technology and know-how exist to achieve this in a cost effective manner. Those municipalities that cannot produce timely and accurate reporting – should borrow locally and not expect to participate in national markets. Or they should not be given (potentially misleading) ratings. Borrowing locally will likely end up costing more than paying the auditor to get the report done in a timely manner.  Hiding behind the “municipals don’t default, so what difference does it make?” argument is so yesterday.

The rating agencies still do not fully incorporate pension and other benefits into the debt statement that produces their debt ratios and medians. Taxpayers certainly do consider these factors. All obligations that are paid from the public purse should be clearly disclosed. Understandably, rating agencies argue that they serve investors not taxpayers. But political risk – unwillingness to pay – clearly reaches back into the investor’s pocket.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

This is a big market, but is not uniformly systemic like housing.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

In some cases. Given our federal system, each state has its own set of rules for local municipal finance. For example financing infrastructure for housing and economic development is vastly different in structure and credit quality in California (Mello Roos for example) vs. Florida (community development districts) vs. Texas (municipal utility districts).

Bookstaber’s point does apply to the municipal market in several ways. Investment portfolios and cash management are prey to marketers of the security “du jour”. As one of his commenters suggests, Fannies and Freddies could put municipal investments systemically at risk of a federal policy change — affecting many municipal government investors at one time. I would add to this list: securities lending practices among pension plans and other large public funds  (which some practice but others do not).

Ratings triggers on counterparties that create terminations, unwinds and a change in interest rates, basically legal provisions that automatically change the terms of the deal — also create across the board risk for those borrowers involved. Examples include variable rate securities, swap transactions, LOCs and GICs. These structures effectively embed corporate and market risk into municipal credit.

At the traditional fixed income municipal debt level however, there is significant diversification among security types and legal structures – given the 10th amendment and individual state peculiarities.

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky — the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Agreed. Analysts and investors should incorporate a haircut for unfunded pension and benefit liabilities that use overly ambitious earnings as a discount rate. The debate about “risk free” vs. a historical earnings rates is an important one. Stated another way, this debate points to the fact that public pensions (defined benefit) are irrevocable, guaranteed and must be paid.  How would you invest funds when you could not afford to lose a penny vs. money you are willing to take on more risk? Since pension obligations are long-lived, the counter-argument that earnings over time should be used has some merit as well.   But the inequities between public retirees and the rest have piqued the taxpayer whose 401K and life savings have been subject to market losses.  Also, the “defined benefit” retirees are facing off against the “defined contribution” beneficiaries.  Fairness is an important public good, as difficult as this debate may be.   

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the underfunded portion of the portfolio.

Absolutely. Maybe they don’t have to do a site visit on each review, but they should disclose the date of their latest full review for each rating, no question. How many of the re-calibrated ratings have been freshly reviewed?

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Disagree. See my comments above and other blog posts on this site. Municipalities do not behave the same as homeowners. Clearly there are scoundrels and irresponsible politicians who just want out of obligations they did not understand or were misled from the get-go.

Even with debt repudiation talk in the air, it is difficult to file bankruptcy in most states, and default is not a good option for a municipality that needs capital markets access. Plus, as covered elsewhere, given the 10th amendment, bankruptcy does not give the federal courts the same kinds of control over a municipality as a corporate entity.

Keep in mind that the majority of municipal borrowers (like the majority of homeowners) want to do the right thing.

Neither are taxpayers irrational. Protests are explainable. There are only certain states where initiatives and referenda are permissible (and this too has historical roots). There are correlations between rapid growth in taxable assets, public spending increases and taxpayer protest. (I have written about this on my blog and elsewhere.) 

Taxpayers are right to be angry at politicians who are spending their money mainly to buy votes and for poor policy reasons. We need to look at the spending patterns in government and have this debate. How many say, “It’s a pre-election year, of course nothing will get done.” In the private sector, someone with that approach would be fired.

Two important worries Bookstaber hasn’t addressed directly:

Liquidity: There are major liquidity issues at some of the states, quickly filtering down to the local level. At least three states have held back making payments to localities and vendors – California, New York and New Jersey. At some point liquidity markets may stop lending – or the cost will become prohibitive — which will have immediate impact on the economy in those states. Where enough taxes roll in the next month to cover payments, these states will limp along until they are able to cure their structural imbalance or they will hit the wall. While some look for a federal bailout in this situation, a failure to tackle the cure for structural deficits is bad policy. As we learned in recent banking crisis, institutions that require regular market funding for survival will fail in a liquidity freeze.

State solvency: tied to the first point, there is no mechanism in our society to address state insolvency. States, as sovereign entities, do not go bankrupt. There simply does not exist any legal or political institution with the authority to facilitate an orderly reorganization of state obligations. We need to think up objective, non-political structures that put the brakes on spending increases when times are good and that facilitate reorganization when times are bad.

Westfall Township, Pennsylvania filed a Chapter 9 bankruptcy petition in April, 2009 and the court confirmed a reorganization plan in March, 2010.  According to the law firm that handled the case:

Westfall Township, located in Pike County, PA, was saddled with a $20 million debt due to a prior government’s mistreatment of a developer.  Without the resources to pay anything close to the amount of that judgment, the township filed for Chapter 9 and was able to negotiate a settlement in the much more feasible amount of $6 million over 20 years without interest.

 “The Westfall Township case was a unique bankruptcy event because municipal reorganizations under the Bankruptcy Code are rarities in the U.S.,” said J. Gregg Miller, an attorney with Pepper Hamilton LLP.  “Filing for Chapter 9 in Pennsylvania requires cooperation between the federal bankruptcy court and the Pennsylvania governmental bureau in charge of financially distressed municipalities.

Pennsylvania is one of several states that have a distressed municipalities program.  Municipalities in these states are supposed to go to the state first, before they file in federal bankruptcy court. 

Why did the township file directly?  Act 47 as the Pennsylvania program is called, has two conditions that may allow a municipality to file bankruptcy directly.  First, the act of filing federal bankruptcy “shall be deemed to be a financially distressed municipality under the act.”  Hmmm. Sounds circular.  Second, if the municipality is in “imminent jeopardy of an action by a creditor, claimant or supplier of goods or services which is likely to substantially interrupt or restrict the continued ability of the municipality to provide health or safety services to its citizens.”  So there needs to be an imminent action against the municipality — not quite the Harrisburg situation at this point.

In the case of Westfall, there was a settlement with a developer a number of years ago that obligated the town to provide water and sewer services to the developer’s property.  The township never acted and the developer sued to get the town to act.  The court sided with the developer, and over time the obligation grew to $20 million. 

The state intervened in the case and the Department of Community and Economic Development appointed a coordinator to work with the township and the bankruptcy court to solve the problem.

Westfall doesn’t have bonds outstanding.  However, bank debt was modified by the bankruptcy court.  $2 million obligations to Dime Bank were suspended until April 10, 2010.  The loan term was extended for ten years at the same interest rate.  A note to Pennstar Bank for purchase of a truck was also extended for three years. 

Adverse settlements against small communities have led to Chapter 9 filings from time to time.  Looking through an official statement for outstanding litigation should be a basic part of an investor or analyst’s underwriting. 

By the way, Johnstown, Pennsylvania, which is under its fourth reorganization plan under Act 47 is considering a filing…see an interesting analysis of Johnstown and other Pennsylvania communities by the Allegeny Institute for Public Policy (conservative think tank) and their discussion of Chapter 9.

The tables below are for contextual reference as state and local governments face draconian spending cuts.   The combination of public policy with the several bubble periods over the last twenty-five years has created a toxic brew.  Some state and local governments are valiantly trying to tackle the issues while other legislatures and councils are more interested in fist pounding.  For those involved in financial analysis (as well as taxpayers) a careful eye is called for. 

State and local spending grew dramatically during the post-Reagan years of the “Program for American Recovery”.  A historic devolution of responsibilities from the federal government to state and local government was coupled with overall economic growth during this period.  I have commented on this issue in prior posts and the presentation I gave at the recent analysts’ conference.  The following tables are expanded to include the 1982-1992 decade.  The first set of columns show dollar increases in 1982 constant dollars.  To account for population changes from migration, which naturally cause increased spending for schools, infrastructure, healthcare, etc. the second set of columns shows the constant dollar increase in per capita spending.   Embedded in these figures are a complex set of decisions on spending, and different approaches to governance, not to mention divergent demographic and economic profiles across the states. 

click image for independent table

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Florida and Nevada top the list in the 1982-1992 decade with spending increases of 105% and 108% respectively.  Florida’s population grew by nearly one-third during this time while Nevada grew by more than 50%.  Per capita spending in Florida increased nearly 58% while Nevada increased 36%. 

On October 19, 1987, Black Monday, the stock market crashed,  followed by the savings and loan crisis and the Gulf War which combined to hit state and local budgets hard.  Mid-term elections during the Clinton administration resulted in Republican control of Congress and the “Contract with America” which further devolved responsibilities to state and local governments.  Some governments slowed their spending increases in the 1992-2000 period.  On a per capita (constant 1982 dollar) basis spending actually declined in some places.  (Note that these are combined state and local figures from the Census Bureau — most other sources, such as Pew, Rockefeller and Center for Budget Policy Priorities focus only on the states.) 

Population growth figures allow some analysis of the changes.  For example, Nevada had nearly 50% population growth which helps to explain a 7% decline in per capita spending during the 1992-2000 period.  New Jersey, in contrast, hard hit by the recession, had only a 7% increase in population but had a nearly 2% decline in per capita spending over the period.

(For the detail oriented reader, there is a minor change in the numbers since I adjusted for 2007 population — the prior tables used 2008 population. Data source: Census Bureau and Bureau of Labor Statistics.  Note that spending includes current year payments for retirement and health benefits but not capital outlay.)

Harrisburg, Pennsylvania can’t really afford to pay for the Resource Recovery bonds that it guaranteed.  Their recently adopted 2010 budget does not include debt service for this guarantee (see prior post with link).  It is accepted practice for rating agencies to rate municipally (or state) guaranteed debt off the credit of the guarantor.  Unlike bond insurance or any insurance for that matter there are no capital set-asides for guarantees by municipal governments.  Market analysts assume that the city or county would raise its taxes to the point of covering the debt.  Harrisburg is now testing that assumption. 

There has been some disagreement on the underwriting floors (at least in bond insurance, if not at the rating agencies) whether one should take into account the credit quality of the project being financed or simply “look through” to the guarantor’s quality.  I suggest a middle ground.  Assume that the Resource Recovery project was rated on its own merits as a project finance — what category would that be?  Then assume a contingent liability on the balance sheet of the guarantor of that lower credit quality.  If it is clear that the guarantor cannot afford the contingency the rating should embed this risk.  This thinking extends to “moral obligation” bonds whose ratings are automatically notched down from the state (or infrequently, local) rating.  Should a “white elephant” project backed by a moral obligation bear the same rating as one that is performing and essential?  (We don’t think so)   Affordability of obligations (add pensions, opeb, debt service to the list) is going to become an increasingly important risk factor as government wrestles with raising taxes, reducing expenditures and satisfying multiple constituencies — unions, taxpayers, retirees and service beneficiaries.

Several states are showing scary illiquidity.  New Jersey’s governor just yesterday impounded funds the legislature had already appropriated and announced a state of emergency.  He stopped short of “declaring” emergency, which would have given him special powers over contracts.  New Jersey comes up high on the list of states with big budget gaps, heavy pension obligations and loudly falling revenues.  New Jersey spending has grown dramatically over the last 25 years.  While there was one state employee for every 86 people in 1982 in the state, today there is one employee for every 60 people.  In the 2000-2008 time period, spending grew 28% on a constant dollar basis.  Debt as a percent of gross state product (adjusted for real 1982 dollars; bear with me) was 11.1 percent in 2008 — among the top ten states, but no where near the US figure of around 60%.  This is not to mention any unfunded pension liabilities plus $1.2 billion borrowing from the US Treasury to make unemployment insurance payments.

Illinois is in the same deep water.  One month ago the state had $5.1 billion in unpaid bills and is delaying payments to vendors by than 90 days.  Crain’s Chicago Business shows columnist Greg Hinz saying its unclear when full insolvency takes place — it just gets slower and slower until business moves out and payroll isn’t met.  

Lets roll back the clock.  The Reagan administration in the early 1980’s proposed the “Program for an Economic Recovery” which devolved programs from the federal to the state and local level.  The action coincided with the end of the 1982-83 recession when the economy took of sharply leaving surplus in many states’ coffers.  For seven straight years state governments increased their budgets 8% each year or 3.2% in constant dollars.   The recession in the early 1990’s left the states poorly positioned to handle the downturn.  Like today, there were mid-year budget reductions, cuts in aid to local government and increases in taxes.  New Hampshire, Rhode Island, Massachusetts, California and Illinois saw ratings downgrades during that time.  Record tax increases led to voter unrest and new tax limitations.  In the mid-term elections, Bill Clinton lost the House of Representatives to a Republican majority.  Newt Gingrich and his party’s “Contract With America” promised 10 bills in 100 days — to further devolve social programs to the states.  Fast forward to the high tech boom in the late 1990’s and bust, then 9/11.  There was monetary easing and policies designed to advance homeownership and voila, here we are today.  I’ve linked two charts that show state spending increases in constant dollars sorted from high to low state expenditure table1992-2000 and state expenditure table2000-2008.  California, for example, held the line during the “Contract with America” years, but expanded 29% between 2000-2009.  Rhode Island also held the line during the first period but grew 30% from 2000-2008.  Illinois grew its budget in constant dollars in both periods — 22% from 1992-2000 and another 20% from 2000-2008.

Also attached is a power point of a talk I gave this week on these topics at the National Federation of Municipal Analysts advanced seminar in Florida.

A blogsite, “Mish’s Global Economic Trend Analysis” recently aggregated a selection of news stories covering state and local government budget deficits and proposed layoffs.  Click here  to link to the post.  There are a few differences between private sector layoff announcements and the public sector that are worth pointing out.   The private sector typically announces layoff actions that are already decided.  There is little incentive to inflate the numbers.  On the other hand, public sector layoff announcements are typically proposals, made in the context of budget negotiations and ultimately subject to the influence of many constituencies: unions, elected officials, civil servants, and service beneficiaries.  I don’t believe it’s common practice for the private sector to lists vacant job positions in their layoff numbers.  Governments typically count the position that has been budgeted for and maybe even funds were appropriated but the position was not filled.

Oregon voters passed Propositions 66 and 67 yesterday which support Governor Kulongowski’s budget proposal.  The following link will give you detail on the propositions, the vote, the key donors to each campaign and the groups advocating pro and con.  Oregon is a high income tax state and ranks high among the states with large budget deficits and high unemployment.  (See state’s post, and stress rankings chart)  This is from Ballotpedia:

On July 20, 2009 Gov. Ted Kulongoski signed two tax bills that will increase taxes in the state by $733 million through increasing the state’s corporate minimum tax, raising taxes on the state’s high-income individuals and raising income taxes on businesses.[1] In reaction to the news, several Oregon citizen and business groups geared up to use the veto referendum process in the state to try to stop the hikes.[2][3]

On October 8, 2009, the Oregon Secretary of State’s office announced that both ballot measures had qualified for the ballot. According to Don Hamilton, spokesman for the Secretary of State’s office, supporters of the measures turned in substantially more than the 55,000 signatures needed to qualify each measure for the ballot. According to Hamilton: “They filed more than twice as many [signatures]. It’s unusually high for a statewide ballot measure.”[4]