Fiscal Crises: The Next Shoe

The fiscal crisis in Greece has recently been in the business headlines.  Readers may also be familiar with the term “PIGS” (Portugal, Italy, Greece, and Spain) or “PIIGS” (if Ireland is included).  This term has been coined as an antithesis to the BRIC economies (Brazil, Russia, India, and China) which, except for some hiccups in Russia, have weathered the worldwide recession with continued economic growth.  The PIGS have all of the same characteristics – high levels of debt and burgeoning deficits relative to their GDPs.  We recently learned that Greece has been hiding some debt and deficits with some creative off balance sheet financial arrangements, courtesy of Goldman Sachs (why am I not surprised?), sort of hearkening back to the good old days of Enron and Worldcom.   In reality, in the scheme of things, Greece, with a population of just over 11 million really isn’t significant when compared to Spain (population 46 million) or Italy (60 million).  So, Europe and the Euro will face continuing fiscal issues once the market lets go of the Greek situation.  More turmoil to come in Europe.

Even more significant that the PIGS is the fiscal crisis now surrounding most of the state and local governments in the U.S.  At last count, 48 of the 50 states had significant fiscal issues, some worse than others.   Here is a list of the seven worst: CA, FL, IL, OH, MI, NC, and NJ.  Each of these states has a population greater than 8 million, each has had to borrow more than a billion dollars to pay unemployment claims, and each of these states has an underemployment rate (the U-6 measure) of more than 15%.

As you would expect, because things happen first in CA, that state leads the fiscal crisis pack.  Itself, the 7^th largest economy in the world, produces 15% of U.S. GDP, has a population of 37 million and an underemployment rate (U6) is now over 21%.  One would think that its $26 billion deficit would have garnered more attention from the market by now. Here are the issues that are common to the state and local governments:

• Unlike the Federal Government, state and local governments must balance their budgets and cannot print money, although CA came up with a near money equivalent when it issued IOUs last fall having run out of cash;
• 55% of state and local revenues are tied to income and sales taxes, both of which have taken a deep dive in this recession;
• A large percentage of the remaining 45% are tied to property taxes; property taxes go down with a long lag as taxing districts are slow to revalue downward;
• States are responsible for a huge chunk of now rapidly rising Medicaid and unemployment benefits (which Congress keeps extending without regard to where the states will get the funding);
• State pension and retirement plans are now significantly under funded despite what appears to be unachievable long-term returns attributed to the future (i.e., returns in the 8% and 9% range when history tells us that, after a debt bubble bursts, long-term returns are significantly reduced).  So the pressure to find funding for existing commitments will plague state and local governments for years to come;
• The gap between salaries and benefits of government employees and private sector employees is now quite significant.  Because of powerful unions and existing contracts often agreed to by officials whose time horizon was the next election, the only solution for these state and local entities appears to be lay offs.  This is true in city budgets (including police and fire), state budgets, and in most school districts.

We, in the U.S., have only begun to see the fallout from the state and local government fiscal crisis.  Such governments account for more than double the GDP share of the federal government. In February, state and local governments laid off more than 25,000.  More lay offs are sure to follow, making it all the harder for the struggling economy to find its legs.

Investors in municipal securities need to be wary.  The state and local government crisis is real, it is huge, and it is just beginning.  The market simply hasn’t yet focused on it, but I assure you, it will.  While history tells us that municipal bonds have low default rates, state and local governments have never faced such a fiscal crisis in our lifetimes.  History isn’t a good guide in this case.  In the 1970s, both New York City and Cleveland defaulted on municipal bonds.  Last year, Vallejo declared bankruptcy, and more recently, the bonds of the Las Vegas Tram defaulted.  More bankruptcies are surely coming.  And, once they start, expect a reactionary flurry (as usual) of downgrades from the rating agencies.  Having been through the financial crisis of ’08-’09, you know the drill.  Expect a lot of municipal bond market volatility.

Robert Barone, Ph.D.