"Being the chief fiscal officer in Illinois right now is like being one of your obituary writers at the newspaper, because I've only got bad news to report all the time." - Illinois State Comptroller Judy Baar Topinka
There are increased indications that the kick-the-can fiscal strategy of states and municipalities is coming to a close, and well before any austerity at the federal level. When the credit agencies get around to serious across-the-board downgrades, you know it's late in the game.
"More than 10 percent of California cities have declared fiscal crises, according to the Moody's, with the most troubled areas lying inland in the middle of the state and east of the Los Angeles area. Kurtter said the declarations of emergency were 'a reflection of the broader fiscal stress in the state.' Moody's floated the idea Friday of an across-the-board ratings adjustment for California cities."
Illinois is back in the news with budgetary problems -- this time to the tune of $44 billion. Additionally, the state has $83 billion in unfunded liabilities, an issue that the legislature can't resolve. Associated Press reports, "That's because the key sticking point is whether schools should shoulder more pension costs: Democrats say yes and Republicans say no. But Stermer said Quinn is not willing to drop the idea of shifting costs to schools. So that leaves Republicans to give in or continue blocking the proposal." Meanwhile, Standard & Poor awaits a resolution on this matter for its decision about another downgrade of Illinois' A+ rating.
The key challenge for states continues to be flat-tax collections. For example, New Jersey tax revenues collected in the fiscal year ending June 30 are reported to be $540 million short. Currently, Republican governors hold 33 state houses and the GOP dominates legislatures. Unless there's an electoral sea change, there's no likelihood that taxes will be raised.
I'm convinced we will see shock-doctrine outcomes applied, especially around state and local government pensions. At issue is $3 trillion in unfunded pension benefits and about $1 trillion in healthcare costs. A big GOP push will develop around legislation requiring more realistic -- rather than inflated -- projections of pension returns. Public pensions allow for exaggerated expectations of 8% returns. State pension funds are struggling with returns, largely because of Zero Interest Rate Policy. New Jersey, another state under pressure, just reported a 2.26% return in the recent fiscal year.
The Republicans will move to put a big stick into the equation. From a James Pethoukoukis article last year, the stage was set:
"Republicans in the House of Representatives already want to stop state and local governments from issuing tax-exempt bonds unless they are more forthright about these future obligations. Republican Representatives Devin Nunes and Darrell Issa of California and Paul Ryan of Wisconsin have introduced a bill that would require state and local governments to estimate the size of public pension liabilities if their assets earned a more conservative rate of return than many plans currently expect. Failure to do so would result in the suspension of their ability to issue tax-exempt bonds."
Paul Ryan is also opposing any form of state or local government bailout. [16 large cities facing bankruptcy]:
"We can't do a bailout. If we bailed out one state, then all of the debt of all of the states is not just implied, but almost explicitly put on the books of the federal government. [Some states] are already telling us [about their dire circumstance]. But should taxpayers in frugal states be bailing out taxpayers in profligate states? … Should taxpayers in Indiana, who have paid their bills on time, who have done their job fiscally, be bailing out Californians, who haven't? No, that's a moral hazard we are not interested in creating."
The final stage of the showdown is to permit states to declare bankruptcy and then clear the way for a restructuring of pension obligations and bond-holder terms. The term for this is a "cram down," and is described by David Skeel. Circling back to Moody's statement on California earlier, that is their concern.
Moody's reports that some cities are turning to bankruptcy as a new strategy to take on budget deficits and avoid obligations to bondholders, an emerging dynamic that could have ripple effects throughout the investment community. The municipal bond market has long been characterized by low default rates and relatively stable finances, Moody's said, but that outlook is beginning to change as bankruptcy becomes a tool for cash-strapped cities.
Just as I "go to press" with this article, the Wall Street Journal reports that "Warren Buffett's Omaha, Neb., company recently terminated credit-default swaps insuring $8.25 billion of municipal debt. The termination was disclosed in a quarterly filing with regulators this month."
The Federal Reserve, notorious for failing to call bubbles, recently weighed in ("Untold Story of Municipal Bond Defaults") on "misperceptions" and using the words "luring investors in" about the muni-bond market, stating, "Although the low default history of municipal bonds has played a key role in luring investors to the market, frequently cited default rates published by the rating agencies do not tell the whole story about municipal bond defaults."
In a Congressional hearing last year, Ben Bernanke was subjected to a round of put-him-on-the-record questions from GOP Senators about muni finance and the Fed's buying of muni issues. Bernanke responded:
'"We have no expectation or intention to get involved in state and local debt,' Bernanke said. The Fed has no authority to buy state or local debt, he said. The Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits the Fed from lending to an insolvent borrower and prohibits it from assisting an individual borrower unless (IT) is part of a bigger program."
Given the small income returns and extremely poor risk-reward, and the unlikelihood that the federal government will have the ability or willingness to engage in rescues and bailouts, investors should head for the exits. There are too many large states and cities in the crossfire, and the fallout of these issues will impact ALL tax free munis.