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When I wrote my piece Watch the State of the States, I did not expect the degree that it would be picked up by other blogs and media. I still think the states are critical to watching the well-being of the nation, and I want to point out a few more items here:

1) There is some good news. Tax receipts are increasing. It would be better if the states were getting ahead of spending, excluding recent subsidies from the Federal Government. When the states get there, unemployment will stabilize.

2) Though conditions in Real Estate are not good in general, there are some bright spots, like condo activity in Miami. Though renting now, that can plant the seeds of stabilization, because it means there is some bottom-line demand for the space. It doesn’t have to be torn down to turn it into orange groves.

3) I agree with Felix, muni bond defaults will not prove to be a source of systemic risk. They are too broadly held; defaults will hurt individuals more than institutions, and it is quite possible that municipalities may make up lost interest payments and become current on their debts again. Unless defaults cascade, and there is a change in the ethics of municipalities not subject to Chapter 9, the effect should not be large, except on the taxpayers who get milked to pay, and the government employees that get laid off.

Now there are some banks with outsized holdings of munis, but they are not the majority of banks. And, though I respect David Goldman, I don’t think the default severities will force the Federal Government to bail out municipalities. The Federal Government may do so anyway, out of intellectual and moral weakness, until its wings get clipped by the global debt markets. But they don’t HAVE to do it.

4) One last bright spot: more states are looking at hybrid pension plans. Hybrid plans combine defined contribution and defined benefit plan attributes. It is one of the few ways of trying to reduce legacy pension promises, if you can get unions and participants to go along with it.

5) But on the negative side, when DB pension funding gets tough, what do plans do? Stretch for return through alternative investments. As I have pointed out on endowments, this is not wise unless you are getting more than compensated for the illiquidity risk.

Illiquidity risk is hard to measure, and only the best risk managers know how to handle it. It comes down to an analysis of illiquid assets versus liabilities, and the need for cash generation for current use. In my experience, most investors trade away liquidity for illiquidity far too cheaply.

6) Now, the worries are inclining many to shy away from muni bonds. I would agree with this, though carefully chosen revenue bonds will do well, as will the states that hold good on their promises.

7) Most states are in trouble, so it should not surprise us that Texas is having problems. It’s in bad shape, but not as bad as many other states.

8 ) Though this is dated, that six states were delaying tax refund payments in June was notable.

9) Five states are getting aid from the Federal Government because they are the worst hit by the fall in housing values.

10) The deficits of many states on a deficit/GDP ratio are worse than Greece; that said, their debts are not nearly as high even if pension deficits are factored in.

11) But states may default anyway to play for time because they are not insolvent but illiquid. Many just need to get their political will together, and times have not gotten tough enough to force that. Oh, who knows, maybe they will sell off some state parks? Or, threaten to cut police rather than less critical spending, in order to force acceptance of tax increases.

12) States are laboratories for policy ideas. One stinker came out of Massachusetts on health care, and now the Feds are imitating it. Read this story to see the problems. Better in my opinion to move the whole country to HSAs. Costs will drop like a stone, and insurers will starve.

13) This piece argues that the Feds should subsidize some state on a one time basis. I think not. If the Feds do subsidize the states, it will become a habit. It has with every other federal involvement in state politics, so we should not do it. It is a good thing that states are being forced to radically trim their budgets. They grew them at far greater than the rate of GDP growth, which was unsustainable. After we cut state services by 20-30%, we should be back to GDP trend. It will force us to prioritize and focus on the things government does well, e.g. justice, security, etc.

Now, I take no delight in the cuts, but states presumed too much out of their tax increases when they were disproportionate the growth in their state economies. Along with financial firms they rode the leverage bubble up. It is only fair now that they ride it back down. They presumed wrongly that every rise in their tax base was theirs to keep. Sorry, but it ain’t so.

Source: A Baker's Dozen Notes on the State of the States