There have been a lot of articles written over the past few months about the perilous state of municipal finances. This one from the FT does a particularly good job, I thought, especially as it highlights the huge role that pension obligations are playing in creating this mess.Here's an excerpt:
Shortfalls in public pension funds are the heart of the matter. State pension deficits are estimated to total at least $1,000bn, according to the Pew Center on the States, a think-tank. Illinois’ pension funds – which pay out to retired teachers, state workers, university staff, judges and politicians – are funded at less than 40 per cent, the lowest proportion of any US state. The gap between assets and liabilities was about $71bn by last September, the most recent available figures.
The unfunded liability could by now have grown to $80bn – more than twice the state’s total annual budget, says Ralph Martire, executive director of the Center for Tax and Budget Accountability, a think-tank.
Some say the shortfall is even bigger. Joshua Rauh, of Northwestern University’s Kellogg School of Management, notes that states generally assume their investments will generate 8 per cent returns a year. “It’s an economic fallacy,” he says. “It would be like taking money from your savings account, putting it into the stock market and then writing down the cost of your mortgage.”
And yet, so far, Illinois has been able to sell enough bonds to keep itself afloat. Most investors assume (as I do) that at the end of the day, the federal government will bail out any state facing insolvency. But that doesn't mean that they're not paying a price:
In spite of recent credit downgrades by Fitch, and Standard & Poor’s, Illinois raised $900m in capital markets last month. In a roadshow covering the US, Europe and Asia, officials and bankers convinced investors – nearly one-third of them non-US – that Illinois would always pay its bondholders.The selling point was that the state requires itself to make bond payments before all other bills. It also offered a hefty premium to comparable US Treasuries – as much as 3.25 percentage points on debt due in 2035. Corporate bonds with similar ratings were paying lower yields. The Illinois bonds have since rallied.
While the markets still have the appetite, the state continues to borrow. It issued $3.5bn in debt last year to pay its pension contributions and plans another $4bn bond for this year’s payment. However, this moves debts around rather than tackling long-term problems.
The state slashed $1.4bn from the current year’s budget, but cost-cutting alone is no solution. Illinois is not, in fact, profligate. Although it is the fifth biggest state by both economy and population, it ranks 45th in state spending as a percentage of gross state product and 46th in its combined state and local tax burden as a proportion of income.
As a group, then, municipal bond holders are pretty sanguine about a situation that most would consider pretty dire. While I too am confident that municipal bonds will pay as promised, I'm not sure that it might not be a little more of a bumpy ride than investors are anticipating.
About 20 years ago, I was involved in selling investment products to Japanese investors. One of the largest funds that I helped sell was sponsored by Fannie Mae. While Fannie Mae was never officially guaranteed by the US government, virtually every investor assumed that the federal government would never let either Fannie or her brother Freddie Mac go out of business.
That feeling was correct - Fannie and Freddie debt has paid as promised. However, both companies are now wards of the US government, with hundreds of billions of taxpayer funds necessary to prop the two companies up. Stockholders of course have been wiped out.
But even though the agency debt was repaid, I can tell you that probably none of the debt holders felt totally secure. And I suspect that the municipal market may be heading in the same direction.
FT.com / Comment / Analysis - America: States of distress
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