Illinois and California Viewed as Equally Likely to Default as Portugal

[donsutherland1]

From CNN's Fortune blog:

...traders are betting that two big U.S. states, California and Illinois, are just as apt to default on their bonds as Portugal -- and almost as likely as Iraq.

The price to insure against a default on Illinois general obligation bonds jumped to an all-time high Thursday. The state, which is facing a deficit that amounts to half its annual budget, has had its rating downgraded by both Moody's and Fitch.

More bets against cash-strapped states - Street Sweep: Fortune's Wall Street Blog

In contrast to Illinois' fiscal situation, the federal deficit amounts to just over 40% of the federal budget. Hence, on a budgetary basis, Illinois' deficits are more than 20% higher than the federal ones. Unlike Portugal, which has an opportunity to take advantage of an EU fund aimed at helping its highly-indebted members buy time to restore their finances, no such framework is available to the states.

Overall, the blog entry highlights the challenging situation confronting the nation's states. It also shatters notions that the states were more prudent fiscally than the federal government. Instead, they developed rigid spending structures that were fiscal time bombs. Those time bombs were then triggered by the sharp drop in tax revenue brought about by the recent severe recession.

IMO, rather than resorting to the business-as-usual fiscal gimmickry of claiming that they are "balancing budgets," as had been the case for years before the housing bubble/financial crisis/severe recession, the affected states would do far better to develop a truly credible plan to achieve a balanced budget within 3 years, moderate and persistent surpluses afterward to build a well-financed "rainy day fund," accompanied by mechanisms and other controls that would assure that the practices that led to the current fiscal vulnerability could not be repeated.

I fully recognize that many would argue that the states are "constitutionally" required to balance their budgets. However, what satisfies that definition is not a genuine balanced budget but typically a balanced operating budget. There is significant latitude for non-budget maneuvers that add debt. That's exactly the kind of gimmickry that destroys fiscal credibility. For example, even in New Jersey where Governor Christie has made some courageous choices, "balance" is achieved by suspending funding of the State's pension plan. Yet, unless the plan's contingent liabilities are reduced (very controversial), the reality is that today's "balance" is merely achieved at the expense of larger deficits tomorrow. In sum, I believe a fiscally credible strategy toward a balanced budget over a reasonable timeframe is far more important and would be far more constructive than a "smoke-and-mirrors" assertion of a balanced budget that falls apart once one looks more closely at the details. To be sure, such a move would require political courage. But it would also be far more honest than the illusions of balancing budgets that prevailed in the past and helped lay the groundwork for the states' dire fiscal situation today.

In addition, states should eliminate the backdoor mechanism of voter-approved bond referenda that was widely used to add debt i.e., bond issues for highway construction, prison expansion, mass transit, etc. Instead, such matters should be treated as ordinary legislative appropriations and subject to regular review vis-a-vis the states' other fiscal needs. Under such referenda, voters who were typically not privy to the state's larger fiscal picture or not inclined to pursue rigorous due diligence, almost always approved what seemed to be good projects. Yet, absent the crucial context of the states' overall financial situation, the decisions were ill-informed, even reckless, and they added to the states' debt burdens (something that should not be occurring were the budgets truly balanced, as they most certainly were not). At the same time, state legislatures and governors avoided accountability from this sleight-of-hand delegation to relatively uninformed voters and the absence of regular legislative review reduced oversight opportunities.

 

[Common Sense Capitalism]

I have friends in Illinois who are getting letters home from their school-age children. The letters tell the parents that they should call their state representatives because the state owes the district $X.

Illinois is in a very sad state of affairs and its about time they got the same default attention as California.

 

[donsutherland1]

Today, The Washington Post reported:

The city's crushing incinerator debt comes atop a $9 million deficit in the current budget, creating an unprecedented fiscal crunch that has left the new mayor and other leaders of this 50,000-resident city weighing unsavory options.

Harrisburg's 1972-vintage incinerator required repeated repairs -- and refinancings -- that put the project $94 million in debt before the federal government ordered the incinerator shut in 2003 because it was spewing toxic dioxin. Faced with eating that debt or refurbishing the plant, former mayor Reed led a push to invest $125 million in incinerator expansion and upgrades. The idea was to create a facility that would draw trash -- and revenue -- from nearby counties and produce steam and electricity that could be sold to local utilities.

But construction delays and design problems surfaced, causing the city to borrow even more millions. The city eventually brought in a new operator, who required more money to get the incinerator going. When the plant was finally operational, it never attracted the envisioned business. Now its steam line is broken, as is one of the turbine blades, eliminating steam sales and reducing its electricity production. The result is that the city has missed several debt payments, which have been made by other bond guarantors.

The decision making responsible for the incinerator debacle illustrates two classic psychological inhibitions to exiting bad projects:

1) The sunk cost fallacy: Past costs, in this case, accumulated debts were used to rationalize maintaining a bad project.

2) Escalation of commitment: When a project is in bad shape, there is often a tendency to pour additional resources into the project under the usually flawed assumption that the additional resources can turn things around.

The article makes no mention, among other things, that:

• The city ever worked with surrounding counties to ascertain their willingness to use the incinerator, much less secured contracts of any kind related to that incinerator. In short, the decision appears to have been made under the hope that "if we build it, they will come." That's a reckless approach, even if it is not unprecedented.

• There were meaningful cost-recovery mechanisms in place. Hence, rather than compelling the contractors and others responsible for the delays, design problems, and cost overruns to bear the financial burden, the city wound up borrowing additional money.

IMO, Harrisburg should re-examine the incinerator. If it does not provide positive cash flow (and it almost certainly does not) and if the city has less costly alternatives for disposing of its trash, it should shut down the incinerator and limit its losses on that project. If possible, it should try to sell the incinerator, even as the sale won't bring a price anywhere close to what the city paid. Nonetheless, some cash could help it recoup a share of its earlier costs. More importantly, either shutting down or selling the incinerator would reduce some of its future drains on cash.

Of course, bankruptcy might yet be necessary. But even if it is not, the city's political leaders will need the willingness to make courageous and difficult decisions to terminate money-losing projects that have little meaningful prospect of long-term viability.

 

[washunut]

States with all those electoral votes need not worry, they will be bailed out by the Feds. If I knew how I would short those CDOs. Maybe I should call Goldman Sachs.

 

[donsutherland1]

States with all those electoral votes need not worry, they will be bailed out by the Feds. If I knew how I would short those CDOs. Maybe I should call Goldman Sachs.

With the U.S. at risk of becoming exposed as the single major OECD state that lacks a credible deficit reduction strategy, fiscal constraints could limit responsiveness to state and municipality deficits. This year, some assistance is still possible. Down the road, prospects could diminish, especially if deficit reduction moves ahead outside the U.S. and, in turn, that development puts increasing focus on U.S. finances.

 

[washunut]

With the U.S. at risk of becoming exposed as the single major OECD state that lacks a credible deficit reduction strategy, fiscal constraints could limit responsiveness to state and municipality deficits. This year, some assistance is still possible. Down the road, prospects could diminish, especially if deficit reduction moves ahead outside the U.S. and, in turn, that development puts increasing focus on U.S. finances.

Agree that he U.S. will be squeezed. Not sure when with so much money sloching around the world with nowhere to invest. Until there is a good alternative from the dollat being the world's reserve currency we will not tighten our belts. Once that does happen all heck will break out. Then states and the Federal government will be in a pickle. The answer will probably be a massive dose of inflation to devalue our debt.

 

[donsutherland1]

From Bloomberg.com today:

Californians don’t see much evidence that the worst economic contraction since the Great Depression is coming to an end.

Unemployment was 12.4 percent in May, 2.7 percentage points higher than the national rate. Lawmakers gridlocked over how to close a $19 billion budget gap are weighing the termination of the main welfare program for 1.3 million poor families or borrowing more than $9 billion in the bond market. California, tied with Illinois for the lowest credit rating of any state, is diverting a rising portion of tax revenue to service debt, Bloomberg Markets magazine reports in its August issue.

The states' financial difficulties are having an impact on GDP. In its just released revision of 2010 Q1 GDP, the Bureau of Economic Analysis noted "a larger decrease in state and local government spending" helped contribute to a deceleration of the growth rate in Q1. Overall, "Real state and local government consumption expenditures and gross investment decreased 3.8 percent, compared with a decrease of 2.2 percent" in 2009 Q4.

 

[donsutherland1]

With respect to Illinois' fiscal challenges, The New York Times reported:

For the last few years, California stood more or less unchallenged as a symbol of the fiscal collapse of states during the recession. Now Illinois has shouldered to the fore, as its dysfunctional political class refuses to pay the state’s bills and refuses to take the painful steps — cuts and tax increases — to close a deficit of at least $12 billion, equal to nearly half the state’s budget.

Then there is the spectacularly mismanaged pension system, which is at least 50 percent underfunded and, analysts warn, could push Illinois into insolvency if the economy fails to pick up.

Last week, The Wall Street Journal reported:

Illinois has rescheduled the date of its $900 million Build America Bond sale, its capital markets director, John Sinsheimer, said late Monday.

Illinois was expected to bring the debt to market as soon as this week, but opted to wait until Governor Pat Quinn made a decision on whether or not he will sign off on the state's budget. Illinois' fiscal year begins Thursday.

IMO, the proposed $900 million bond offering should be canceled. Illinois should not be taking on new debt until it develops and implements a credible fiscal recovery plan. As noted previously, such a plan should propose returning to balanced budgets (entire budget, not operating budget) within three years.

 

[washunut]

IMO, the proposed $900 million bond offering should be canceled. Illinois should not be taking on new debt until it develops and implements a credible fiscal recovery plan. As noted previously, such a plan should propose returning to balanced budgets (entire budget, not operating budget) within three years.

I think you would agree that while your desire above may be the correct answer that is not what will happen.

States like Ill. will be an interesting case study for the Federal government's problems. Since the states can't print their own money, they need to rely on the feds to bail them out. In that way it is somewhat similar to Greece and Spain.

The case study is what do politicians do when they are faced with this fiscal problem. They have used the taxpayers money as a piggybank to keep their voters happy. Who will have the guts to take some of the goodies away, do the right thing and perhaps lose an election because of it.

You pointed to a key element that needs to be fixed which are government pensions. That might be an area to go after. Even relatively painless changes would make a huge difference in state budgets.

 

[donsutherland1]

Washunut,

I agree with you and I fully expect that the bond offering won't be canceled. I do believe it would be helpful if the ratings agencies, rather than being typically reactive, substantially downgraded states such as Illinois. IMO, the current A1 rating enjoyed by Illinois is overly generous and does not fairly represent the actual magnitude of the state's fiscal position and lack of policy effort to address that fiscal situation.

In terms of federal financial assistance to the states, I believe such assistance should come with very strong strings attached including: 1) A credible plan to bring unified budgets into balance within three years; 2) Pensions would be adjusted/reformed over a period of years; 3) State debt as a share of state GDP would be capped and then reduced over a period of years. At the same time, the federal government could be helpful by reducing unfunded mandates on states.

 

[washunut]

Washunut,

I agree with you and I fully expect that the bond offering won't be canceled. I do believe it would be helpful if the ratings agencies, rather than being typically reactive, substantially downgraded states such as Illinois. IMO, the current A1 rating enjoyed by Illinois is overly generous and does not fairly represent the actual magnitude of the state's fiscal position and lack of policy effort to address that fiscal situation.

I think the rating agencies take into account the probability of a fed bailout. It would be interesting to know if that is part of their considerations.

In terms of federal financial assistance to the states, I believe such assistance should come with very strong strings attached including: 1) A credible plan to bring unified budgets into balance within three years; 2) Pensions would be adjusted/reformed over a period of years; 3) State debt as a share of state GDP would be capped and then reduced over a period of years. At the same time, the federal government could be helpful by reducing unfunded mandates on states.

I think the big states feel that they have the fed government in a bind. By that I mean if they default other states and the fed gov't might get downgraded by the rating agencies. It will be an interesting next couple of years as this plays out.

 

[donsutherland1]

From CNN:

On Wednesday, it plans to raise $900 million through Build America Bonds to fund its first capital program in more than a decade. The money will be used to improve roads, bridges and schools.

And this debt issuance is only the beginning. The state plans to raise $1.3 billion in short-term notes next week and $1.4 billion in debt related to tobacco settlement funds in November.

And, the state plans to turn to the debt markets to fund $3.7 billion in pension obligations in December, if the state legislature approves. The state already sold $2.4 billion in pension notes in January.

IMO, this latest disturbing development risks pushing Illinois somewhere toward the boundary between a "speculative" unit and a "Ponzi" unit, as defined by Hyman Minsky. A speculative unit's cash inflows do not cover payment commitments on debt (principal and interest) but are sufficient to cover interest costs. A Ponzi unit is unable to meet its interest payments without incurring new debt. As a unit approaches the boundary between a speculative and Ponzi situation, a rise in interest rates and/or fall in cash flow can lead to its becoming a Ponzi unit.

At the same time, Illinois is leveraging a 35% federal subsidy for the issuance of "Build America" bonds. Congress would do well to revise the subsidy to make it contingent upon a state's financial position so as to avoid creating a situation of backdoor subsidies for a state's becoming overleveraged.

The ratings agencies, generally behind the curve when financial positions deteriorate, should downgrade Illinois toward or at junk status. Perhaps only that outcome, which would likely limit Illinois' access to the debt markets, would bring an end to what is becoming an almost unprecedented example of fiscal recklessness. Illinois' intent to leverage underfunded pension funds is fiscal dynamite and amounts to extraordinary disregard for the state's wellbeing.

IMO, using borrowing to facilitate a transition to a credible three-year program aimed at balancing the state's budget and then running surpluses to begin reducing debt would be acceptable. Illinois is taking no such approach.