My brother, a scenic design artist in Hollywood, who has no understanding of economics at all, summed up the California budget problem like this:
The Government asks,”Who wants ice cream?”
And everybody answers, “We want ice cream!”
The Government asks “Who wants to pay for the ice cream?”
And everybody answers “We don’t want to pay for it!”
That is the municipal fiscal crisis in a nutshell.
Cities and states have the same problem as banks and real estate did a few years ago – too much debt. It is part of the still unfolding Fiscal Crisis that started in 2007.
It is an age old problem – you can’t spend more than you take in. States, cities, towns and counties across Americ
a are learning that hard fact. The solution is going to require unpopular spending cuts, reductions in services and unpopular tax increases. There is no painless way out of this Fiscal Crisis.
What surprises me is how few investors are aware of the issues. This report will go over the major issues and the resulting impacts for investors. The issues are as follows:
1. Unfunded Pension Liabilities
2 . Rising Exp enses
3. Declining Revenues
The National League of Cities recently published a report that concurred with the above list. In “City Fiscal Conditions in 2010” they reported that “cities are cutting personnel, infrastructure investments and key services… Property tax revenues are beginning to decline in 2010, after years of annual growth, reflecting the gradual, but inevitable, impact of housing market declines in recent years… Large state government budget shortfalls in 2010 and 2011 will likely be resolved through cuts in aid and transfers to many local governments…”
But unfunded liabilities were the biggest challenge. “Two of the factors that city finance officers report as having the largest negative impact on their ability to meet needs are employee-related costs for health care coverage and pensions. Underfunded pension and health care liabilities will persist as a challenge to city budgets for years to come…”
They don’t see improvement anytime soon. “Confronted with these issues, 80 per cent of city finance officers forecast that their cities will be less able to meet needs in 2011 than they were in 2010.”
Cornerstone has been writing that the next shoe to drop in the Fiscal Crisis would likely be in the Muni area and recent developments seem to bear that out.
Meredith Whitney, an analyst that made her name by predicting the banking crisis while at Oppenheimer, has recently given a gloomy analysis of the Muni bond market.
In an interview on 60 Minutes in December 2010, she said “You could see 50 sizeable defaults. 50 to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars’ worth of defaults” Steve Kroft from CBS 60 Minutes goes on to say “Right now the big bond rating agencies like Standard & Poor’s and Moody’s, who got everything wrong in the housing collapse, say there’s no cause for concern, but Meredith Whitney doesn’t believe it.”
Cornerstone believes that just like the Banking crisis and the Real Estate collapse, the Muni market meltdown is/was easy to see if you just look at the numbers. And yes, the ratings agencies missed both the housing and banking problems by a mile.
1. Unfunded Liabilities
Although Unfunded Liabilities show up as a cost to the municipality, we are going to treat it as a separate subject because it is by far the biggest issue states and cities face. It is both a cost and an off-balance sheet debt.
Simply put, an Unfunded Liability is money owed to someone in the future that the municipality has not set aside any money for. If the Fire Chief is going to retire in 10 years and the actuarial tables indicate the city will need $1,000,000 set aside for his pension and they only have $200,000 set aside, that is an Unfunded Liability of something less than $800,000.
($1,000,000 may sound like a lot of money, bu
t at 5% interest, it only generates $50,000/year. This could be below the target area for a Fire Chief’s defined benefit plan. Since most retirement pensions are calculated like annuities, giving a lifetime income, his payout would be higher, but the principal would deplete over the years. Bottom line, the Fire Chief won’t be getting a check for a million dollars at retirement, but a city may need to have that much money set aside to get him a retirement of a certain predetermined amount – the Defined Benefit Pension.)
The Unfunded Liability in our example is less than $800,000 because the $200,000 they have already set aside will/should grow. It could grow as little as 1% per year, giving the city $221,000 to fund his retirement, far short of the $1,000,000 target. Even if the funds grew at 8% annually, his pension would be about $431,785, less than half the way to the target. At an 8% annual return, the city would have to add $265,000 to the $200,000 already in the pension fund today to get to the target of $1,000,000 for the Fire Chief. (450,000 X 8% annually = $1,003,900) If the City’s pension goes through another 10 years in the stock market like the last 10 years, the city may have to come up with the entire $800,000 at the Chief’s retirement.
To the detriment of municipal workers and tax-payers, many state and city officials have treated these expenses as “somebody else’s problem” and have kicked the can down the road for the next administration to deal with. This also appears to be the attitude of many current analysts on Wall Street that feel the worries about the muni market are overblown. (If I recall correctly, most of Wall Street failed to recognise the mortgage problems and the banking crisis also.)
How Big is the Problem?
Depending on how you do the maths, (future liability projections can vary due to projected rates of return), the Unfunded Liabilities at the State level is between $2a and $3b TRILLION. To put this into perspective, the entire Municipal Bond market is about $3 trillion dollars. On top of that, local municipalities have an additional $500 – $600c billion Unfunded Liabilities.
Deeper studies have found the maths gets even trickier. California, by itself could have an unfunded liability of as much as $500 billion. On April 6, 2010, a Story by David Crane in the LA Times stated “The state of California’s real unfunded pension debt clocks in at more than $500 billion, nearly eight times greater than officially reported. That’s the finding from a study released Monday by Stanford University’s public policy program, confirming a recent report with similar, stunning findings from Northwestern University and the University of Chicago. To put that number in perspective, it’s almost seven times greater than all the outstanding voter-approved state general obligation bonds in California.”
This isn’t a Democrat or Republican issue, the cause spans multiple administrations at the local and state levels.
A leading Democrat, Orin Kramer, who was New Jersey’s Pension Fund Chairman and still on the investment policy committee, has voiced his concerns about not only the size of the Unfunded Liabilities but also the methodology in managing the funds and what the fallout will be. “US public pensions face a shortfall of $2,500 billion that will force state and local governments to sell assets and make deep cuts to services, [Kramer] has been an outspoken critic of public pension accounting, which allows for the averaging of investment gains and losses over a number of years through a process called “smoothing”.” He goes on to say “States face cost pressure, most prominently from
retirement benefits and Medicaid… One consequence is that asset sales and privatization will pick up. The very unfortunate consequence is that various safety nets for the most vulnerable citizens will be cut back.” – Orin Kramer, US public Pensions Face 2500bn Shortfall 01/17/2011 Financial Times
Studies have shown that the Unfunded Liabilities will have far reaching impacts on State and Local budgets for years to come. As time moves forward and nothing is done about the Liabilities, they grow larger to the point where the pension system can run out of money and even consume all of a municipality’s revenues. “Assuming future state contributions fund the full present value of new benefits, many state systems will run out of money in 10-20 years if some attempt is not made to improve the funding of liabilities that have already been accrued. The expected shortfalls raise the possibility that the federal government will be faced with a decision as to whether to bail out states driven to insolvency by their pension programs.” – Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities – Joshua D. Rauh Department of Finance, Kellogg School of Management, Northwestern University
An April 2010 study by Andrew Biggs at the American Enterprise Institute for Public Policy Research concluded that “On average, public sector pension plans have only a 16 per cent probability of being able to cover accrued benefit liabilities with current assets.”
The chart to the right shows several cities and their ratio of Unfunded Liabilities to annual revenues. Many cities in the study showed ratios of over 300%. This means that it would take 3 years (or more) of 100% of the city’s annual revenues to fill the hole they have in their pension. This obviously cannot happen.
2. Rising Expenses
Communities across the country are slashing budgets, laying off employees and reducing services. And this isn’t enough to fill the holes in their budgets.
One cost that may end up being a surprise is the rising cost of financing. Until recently, the Muni bond market has been a friend to the states and cities. But recent sell offs have driven rates higher. Rising interest rates means higher cost for municipalities that are trying to cut costs. Borrowing money is becoming less attractive as rates rise.
As the problems with the balance sheets and income statements becomes better understood, ratings agencies could start a wave of rating downgrades. “Downgrades of bonds issued by state and local governments could increase this year, according to a report to be issued Monday by credit-rating agency Standard & Poor’s” – Warning From S&P on Munis 01/24/2011, WSJ, Jeannette Neumann
Lower ratings means higher interest rates for issuers. An increase of 1/4% to 1/2% could mean millions in additional costs to a City or State.
3. Declining Revenues
“This is the state of affairs in Illinois. [It] is not pretty,” Illinois state Comptroller Dan Hynes told [Steve] Kroft. Hynes is the state’s paymaster. He currently has about $5 billion in outstanding bills in his office and not enough money in the state’s coffers to pay them. He says they’re six months behind. “….”It’s fair to say that there are tens of thousands if not hundreds of thousands of people waiting to be paid by the state,” Hynes said. …Illinois legislators that have been evicted from their offices because the state didn’t pay their rent, and stories about state troopers being turned away from gas stations because the owners refused to take their state credit cards.” – Dec. 19, 2010 State Budgets: The Day of Reckoning Steve Kroft Reports On The Growing Financial Woes States Are Facing.
The recession and Fiscal Crisis has hit State and Local incomes hard. Declining tax revenues and declining property taxes have put a squeeze on budgets. “Los Angeles Mayor Antonio Villaraigosa, a Democrat, said municipalities are being squeezed as states move to balance their own budgets, a step that can involve taking more funds that would otherwise be sent to towns and cities. “There’s no question you’ll see some cities in default,” Villaraigosa told reporters today at a press conference in Washington, where the U.S. Conference of Mayors is meeting. “The difference between us and the federal government is they can print money. The states balance their budget oftentimes on the backs of cities, counties and school districts. We actually have to balance a budget.” Defaults by Cities Looming as U.S. Mayors Say Deficits Hinder Debt Payment By William Selway – Jan 19, 2011 Bloomberg
The main revenue sources for States are Income Taxes and Sales taxes. They also rely on intergovernmental transfers from the Federal Government. Local municipalities rely on property taxes, some sales taxes and intergovernmental transfers from the state.
According to The Congressional Budget Office (CBO) property taxes average about 26% of cities and towns revenues, while Intergovernmental Transfers (from the state) average 30% of their total revenues.
Locals could end up seeing a large part of that 30% of their income disappear as money from the Federal Government to the States slows and then from the states to the local level slows. “$160 billion in federal stimulus money, t
hat has helped states and local governments limp through the great recession, will run out. [this spring] – Dec. 19, 2010 State Budgets: The Day of Reckoning Steve Kroft Reports On The Growing Financial Woes States Are Facing.
“The big problem is that cash-strapped states will no longer be able to provide the financial support to municipalities as they have in the past, said Whitney. “States clearly have been funding municipal governments—for now up to 40 per cent of their total expenditures,” she explained. “As the states become more compromised from a fiscal standpoint, that funding is going to end. The federal government is unlikely to bail out the states either, added Whitney, because the cost —which she put at $1 trillion—would cause a political backlash. “Who in Nebraska’s going to want to bail out someone in Florida?” she said.” Wave of Muni Defaults to Spur Layoffs, Social Unrest: Whitney 21 Dec 2010 Business Insider
The second main source of income for cities and towns is property taxes. There has been some decline over the past few years. Foreclosed homes don’t pay taxes and people behind on their mortgage tend to be behind on their taxes as well.
The big drop in property tax revenue could start to unfold this year. There tends to be a delay in property tax declines and property values. Property tax values from 2005, 2006 and 2007 are likely to be much lower in the next few years since real estate prices have declined so much. In some places real estate values have declined 50%.
The CBO recently put it this way: “Nationally, house prices fell by 27 per cent from the year ending in June 2006 to the year ending in June 2010. Although property tax collections increased 31 per cent over that same period, the decline in house prices implies that collections will probably fall in the coming years as local governments gradually update property tax assessments to reflect lower market values. On average, collections of property tax revenues lag behind changes in house prices by three years. Even small declines in collections could cause fiscal stress when the cost of providing public services is growing.” – Fiscal Stress Faced by Local Governments – CBO 12/2010
Property tax re-valuations are every 5 years in many communities, so there could be a wave of lowered property taxes starting this year. This lower tax base could put another strain on city’s and town’s budgets.
Unfortunately, politics got us into this mess, but it is very unlikely to get us out. Tax increases are opposed by one side of the aisle, while spending cuts are opposed by the other. Each side has to give, and give a ton to get many of the States and cities out of trouble. There is no economically pain free way to fix the problem. There is not politically pain free way t o fix it.
“Gov Chris Christie of NJ “The reason it’s different is because the only choices left are choices that people previously have said were politically impossible… You couldn’t cut K to 12 education funding. …you couldn’t talk about pension and benefit reform for the public sector unions. [They] were third rails of politics. We are now left with no alternatives.” Dec. 19, 2010 State Budgets: The Day of Reckoning Steve Kroft Reports On The Growing Financial Woes States Are Facing.
The public is no help.
The recent protests around the country show just how little the public understands the problems. The cities and states do not have the money to pay for all the services they offer and the obligations they have. Deep spending cuts, while not fun, are a requirement to get the cities and states out of their fiscal crisis. But each special interest group, when faced with potential cuts, gets up in arms and challenges the resolve of the politicians.
History shows there is no reason to have any faith in the resolve of politicians, except when it comes to getting re-elected. Politicians will talk a good talk, but they are very familiar with the public opinions that are illustrated in the charts on this page. When you have wide divergences between for and against, you can be sure to find most politicians on the side with the majority opinion. In the case of spending cuts, I think it will be hard to find a group of politicians willing to commit political suicide by voting in favour of deep spending cuts and against the majority of the public.
Since the public is solidly against spending cuts, they must be in favour of tax increases. No, they aren’t. They are almost as solidly against tax increases.
So what are politicians to do? The public doesn’t want tax increases or spending cuts, but the budget imbalances demand it. Are we about to see a heroic new class of politicians at the state and local level “who will take one for the team” and do the right thing, against public opinion, risking their futures in politics by staying committed to deep spending cuts and raising taxes.
Nah… No way.
Unfortunately, politicians have proven over the years that they are more likely to do what is popular, what will get them re-elected, not what is right. The Fallout
The result of the muni mess is likely to be a snowballing of Unfunded Liabilities, larger debts and defaults and municipal bankruptcies. “JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said he expects more U.S. municipalities to declare bankruptcy and urged caution…” JPMorgan’s CEO Dimon Says More U.S. Municipalities May File for Bankruptcy By Christopher Palmeri and Andrew Frye – Jan 12, 2011, Bloomberg
“A wave of defaults by state and local governments in the coming months will spark a selloff in the municipal bond market, hurting US economic growth and stocks and causing social unrest as governments are forced to lay off workers and cut back on services, well known financial analyst Meredith Whitney told CNBC Tuesday.” Wave of Muni Defaults to Spur Layoffs, Social Unrest: Whitney Published: Tuesday, 21 Dec 2010 Business Insider
Many investors do not realise the risks they are taking with muni bonds. At this point, the potential for default is real.
“Policy makers are working behind the scenes to come up with a way to let states declare bankruptcy and get out from under crushing debts, including the pensions they have promised to retired public workers…
The biggest surprise may await the holders of a state’s general obligation bonds. Though widely considered the strongest credit of any government, they can be treated as unsecured credits, subject to reduction, under Chapter 9″ – Path Is Sought for States to Escape Debt Burdens By Mary Williams Walsh NY Times
We already have an example of what happens when a town declares bankruptcy. Vallejo, California recently declared bankruptcy. According to The Bond Buyer, in a report on 01/19/2011, as part of their re-organisation plan, unsecured creditors would receive between 5 and 20 cents on the dollar. Many bond holders can be considered unsecured creditors.
Moral Hazard Expands
If the Fed is willing to bail out Citi, why not California, or NYC, or Central Falls? In many cases, strict austerity programs and higher taxes will solve the fiscal problems. But in too many cases, the numbers are impossible. Some states and cities cannot cut enough out of the budget nor raise taxes high enough. They will be left with few options – default, bankruptcy or begging for a Federal Bailout.
It is our opinion that the Fed and/or Treasury will step in and bail out troubled states and cities that are on the verge of collapse. The exact details will be sold as a new step forward in cooperation between the Federal government and the states, or some other nonsense. Bottom-line, no matter what they call it, the Fed will have to pump more money into the system by running the their printing presses overtime, continuing to debase the greenback.
And once one city or state asks for, and gets help; what is to stop other municipalities, even ones that are struggling, but not on the verge of collapse, from asking for, and getting a bailout from the Fed. It is the fast, easy, and politically expedient way to solve the problem. It is a major kick of the can down the road. Let the next group of politicians figure out how to solve the problems. Investment Implications
Avoid Long Term & Int Term Muni Bonds – This is the obvious step. Bonds tend to trade in a group. Similar bonds trade like the worst one in the group. So if a city in Tennessee goes bankrupt, bond traders will scour the market to find and dump any other bonds that are similar to the ones from the city that just defaulted. Then other bonds that are somewhat similar will get hit and eventually the entire market may feel it.
As more states and cities have problems, the muni sell-off will broaden and deepen.
Short Bonds – The next best thing to do is to try to profit from the muni market decline. While there are not any inverse muni funds, there are some inverse Treasury funds and there may be enough of a sympathetic move in treasuries to benefit the inverse fund.
Hedge Dollar’s Decline – As the Fed continues to print Dollars, the value declines. Investments that can benefit from a declining dollar include foreign stocks and bonds, Emerging market stocks and bonds, commodities and hard assets, gold and inverse dollar funds.
Hedge Inflation – As the Dollar declines, inflation can heat up. The prime beneficiaries of inflation are gold, commodities and TIPs (Treasury Inflation Protection bonds)
Other Sources of Income – Many investors own Muni bonds for the income, but today there are a variety of income sources for investors including foreign and emerging market bonds, dividend paying foreign stocks and dividend paying commodity companies.
Not the First Time
In the January 4, 2011 issue of The Wall Street Journal, there was an article titled When States Default: 2011, Meet 1841. A real estate boom crashed in 1841, bring down with it banks and states. Sounds familiar? The Federal Government did not bail out the states for fear of creating a Moral Hazard, or as they put it: it would “cause recklessness and extravagance” among the states. This was because in 1841 they had a “moral duty” of meeting debts.”
Contrast that with today. Councilwoman Susan Brown Wilson from Harrisburg, Pa, a city that just went bankrupt and needed a bailout from the state, recently said “By no means should the citizens of Harrisburg [alone] be strapped with the debt created eight years ago by a prior administration.”
What? Is she kidding? As Horsesmouth.com asks – “Are we not responsible for what past administrations have done? Isn’t that the principle that secures any bond issuance?”
“If Wilson’s attitude becomes the prevailing attitude, muni bonds are nothing more than colourful paper.”
a – US public pensions face a shortfall of $2,500 billion that will force state and local governments to sell assets and make deep cuts to services, according to the former chairman of New Jersey’s pension fund (Orin Kramer). Mr Kramer, an influential figure in the Democratic party and still a member of the investment council that oversees the New Jersey pension fund, has been an outspoken critic of public pension accounting, which allows for the averaging of investment gains and losses over a number of years through a process called “smoothing”. US public Pensions Face 2500bn Shortfall 01/17/2011 Financial Times
b – roughly $3 trillion (or almost $27,000 per household) unfunded liability of all state‐sponsored pension plans in the U.S. – The Crisis in Local Government Pensions in the United States ROBERT NOVY‐MARX, UNIVERSITY OF ROCHESTER AND NBER JOSHUA RAUH, KELLOGG SCHOOL OF MANAGEMENT AND NBER October 2010 Revised October 13, 2010
c – the total unfunded liability for all municipal plans in the U.S. is $574 billion The Crisis in Local Government Pensions in the United States ROBERT NOVY‐MARX, UNIVERSITY OF ROCHESTER AND NBER JOSHUA RAUH, KELLOGG SCHOOL OF MANAGEMENT AND NBER October 2010 Revised October 13, 2010
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