I’ve been warning for months that a few state and municipal bankruptcies (actually, a few states and a great many city bankruptcies) will be required to slay the beast of government-union pension liabilities. The total size of the muni bond market is about $2.4 trillion. Unfunded pension liabilities (calculated with a realistic discount rate) are almost as high, according to one study. Now comes James Pethokoukis of Reuters to tell us of a “secret GOP plan” to bankrupt local governments and crush the government unions.
Congressional Republicans appear to be quietly but methodically executing a plan that would a) avoid a federal bailout of spendthrift states and b) cripple public employee unions by pushing cash-strapped states such as California and Illinois to declare bankruptcy. This may be the biggest political battle in Washington, my Capitol Hill sources tell me, of 2011.
That’s why the most intriguing aspect of President Barack Obama’s tax deal with Republicans is what the compromise fails to include — a provision to continue the Build America Bonds program. BABs now account for more than 20 percent of new debt sold by states and local governments thanks to a federal rebate equal to 35 percent of interest costs on the bonds. The subsidy program ends on Dec. 31. And my Reuters colleagues report that a GOP congressional aide said Republicans “have a very firm line on BABS — we are not going to allow them to be included.”
In short, the lack of a BAB program would make it harder for states to borrow to cover a $140 billion budgetary shortfall next year, as estimated by the Center for Budget and Policy Priorities. The long-term numbers are even scarier. Estimates of states’ unfunded liabilities to pay for retiree benefits range from $750 billion to more than $3 trillion.
I’m not going to trade in Capitol Hill rumors, but whether there is a secret plan or not, the US federal government is in the same position that Germany is with respect to Greece — the creditors (in this case public employee pensions) have to take a massive haircut for the numbers to add up. The delayed effect of the real estate collapse (which is still getting worse) is going to hit local revenues next year due to massive downward adjustment in tax assessments. This is the killer.
It’s cities, not states, that live off real estate taxes. Local government was riding the real estate boom along with everyone else but it takes a couple of years for the price collapse to work its way through tax assessments. What’s going to happen is two, three, many Harrisburg bankruptcies. The cities will collapse and the states will push them over the edge (like NY State with NYC in 1974). They’ll make a horrible example of a couple of states — California and Illinois — others will hold the line as the cities go down like ninepins.
There are nearly 11 million local government employees (not counting 3.56 million part-time), or a full-time equivalent of 12.2 million. Full-time equivalent for states is only 4.4 million. So most of the savings (and union-busting) has to come from local governments in the first place.
There’s a limit to how far they can take this: banks and insurance companies together have about $700 billion of munis. You can wipe out mom and pop (did so already with the auction securities market) but a 40% haircut would take out about $300 billion of financial institutions’ capital — not pretty. And that’s not to mention the spillover effect on other markets. That’s yet another reason not to own the banks’ common equity.
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My best guess is that two states go down — Illinois and California — and lots of Democratic city machines. In lots of states, Republican governors and state legislatures will actually win support by running against the machines.
If you have to own munis, own the better-quality states – in fact, own bonds that have first claim on revenues rather than general obligation debt. The municipal bond funds are loaded with School District of West Squashbug and the general obligation bonds of Death Gulch. Even if you own bullet-proof munis (and I own some myself) be prepared to take a big mark to market hit as the crisis plays out.
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