US states and cities are running up record sums of debt. Most investors are complacent but are they right to be? Simon Wilson investigates.
What's going wrong?
US state and local government borrowing as a percentage of US GDP is at an all-time high of 22% this year. And it is projected to hit 24% by 2012. Outstanding debt has soared to $2.2trn today from $1.4trn in 2000. States have failed to cut spending, while the recession has seen tax revenues plunge by double-digit percentages. Local and state governments across the US face cash-operating deficits of $200bn, or 15% of their budgets, this coming year alone. And it is some of the biggest states, such as California and Illinois, that are most exposed. All that has raised fears that municipal bond-lending to state and local government is far riskier than previously thought.
How is this playing out?
In Michigan, for example, huge job losses stemming from auto-industry bankruptcies have left the state with 13.6% unemployment, the second-highest rate in the US after Nevada. In turn this has crushed property values down 74% from the peak and property tax revenues. In March, Detroit warned of bankruptcy, and has appointed emergency financial managers to narrow the city's deficit. Meanwhile, New York State, with a $9.2bn deficit, has only avoided a shutdown because its Legislature has approved emergency spending bills. Yet this could be just a stay of execution. "Experts are unsure if the police, firefighters, prison guards, emergency and healthcare workers can go to work if they can't be paid," says Joan Gralia at Reuters. "You could have anarchy literally in the streets if the government shuts down," warns Governor David Patterson. Yet despite plenty of wrangling about spending cuts, Democratic Assembly Speaker Sheldon Silver says there is still no agreement on any tax hikes or borrowing plans.
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Who is worried?
Warren Buffett for one. His investment vehicle Berkshire Hathaway has been trimming its exposure to municipal debt. He warned last year that public officials might be tempted to default on bonds when payments are guaranteed by insurance companies, rather than push through necessary tax rises. In other words, there is political risk attached. This helps explain why spreads on credit-default-swaps (which indicate how worried investors are about a default) are wider for some US states (including California and Illinois) than for Portugal or Ireland.
Is everyone concerned?
Most investors and credit rating agencies are more sanguine than Buffett. "We do not expect that states will default on general-obligation debt, even under the most stressed economic conditions," wrote an analyst at Moody's in a report earlier this year. "As for towns and cities, we expect very few defaults in this sector, given the tools that local governments have at their disposal." Rival Standand & Poor's hold the same view.
Why are they so calm?
Firstly, states and cities desperately need to keep borrowing, and so have every reason to avoid default as this would make future borrowing much harder and costlier. Second, investors think lending to states is low-risk because they can always tax their way out of trouble. And third, the law makes default very hard. States can't legally declare bankruptcy to escape debt and none has done so since Arkansas in 1933. Meanwhile, half of the states don't allow local governments to declare bankruptcy, and federal law prohibits the kind of strategic Chapter 11 bankruptcy that allows businesses some breathing space. Local governments may only go bankrupt if they can prove they can't pay any bills and no one will lend them money.
Are they right to be relaxed?
Probably not. One worrying sign, as The Economist notes, is that some states are already bending the rules to get around existing constitutional barriers to borrowing more money. For example, New York requires voters to approve any general-obligation bond, i.e. borrowing that is not covered by specific, earmarked revenues. So instead, since 2002, it has relied on bonds backed by personal income-tax revenues which don't need voter approval. And in January, Illinois issued $3.5bn in bonds to cover its pension payments to retired public-sector workers, although pension obligations are clearly a current, operating expense. And raising this money is getting much pricier as investors become more risk-averse in general. As Tom Boylen at BMO Capital Markets puts it: "There's a bigger magnifying glass on credit". By 2018, Illinois will be paying $14bn a year in benefits, a third of its overall revenues, compared to $6.5bn now. That should worry bondholders, argues The Economist, especially given that several state constitutions, (including Illinois' and New York's), rank state pensions over bond debt in a default.
Would Washington save a bust state?
Investors would be unwise to rely on Uncle Sam coming to the rescue if a state defaulted or simply refused to pay its debts, argues Manhattan Institute Fellow Nicole Gelinas in a recent City Journal essay. The uncomfortable truth is that as states and cities become more indebted, there's a greater risk that at some point it will be politically, economically and financially worthwhile for them to try to escape their obligations. If and when that happens, lenders should look to recent corporate bailouts such as AIG, Chrysler and General Motors, in which bondholders got a raw deal. Faced with the competing demands of social cohesion and saving bondholders, Washington would most likely throw some creditors out of the bailout boat.
