While
not everyone believes state and local budget problems are severe
enough to create a ripple effect of bankruptcies, it is nevertheless
unsettling to recall that the Great Depression actually began -- and
was prolonged -- as various municipalities, mostly in the South and
Midwest, began cutting services and defaulting on bond debt. A
re-play of the Great Depression notwithstanding, the one thing most
agree on is that states and communities with high levels of debt and
poor revenue prospects will at the very least see the cost of
borrowing head skyward, as investors head for cover.
Compounding
muni-market fears is the fact that, while investors of muni bonds may
at one time have been lucky enough to have ended up with the
equivalent of a piece of Central Park in satisfaction of debt
defaults, today many such investors may not fare so well. This is in
part because the states themselves are ill-prepared
to
help themselves much less troubled municipalities, and in part
because, in the words of SEC
Commissioner Elisse Walter,
"investors in municipal securities [have become] in many ways
'second-class citizens' who [do] not receive the protections
customary in many other sectors of the U.S. capital markets."
Although
states themselves cannot declare bankruptcy and typically look to
other ways to satisfy their debt obligations including recasting
pension contracts, increasing taxes and slashing programs, they can,
at their discretion, help municipalities in trouble. States are,
however, much less likely to provide such help when they themselves
are in financial trouble. So what happens when a state refuses to
rescue a troubled municipality? The municipality can potentially be
forced into bankruptcy, leaving bond holders holding the bag.
As
fiscal pressures have mounted, states seem to be turning to
unorthodox methods in order to remain operational. This is verified
by new evidence,
emerging as a result of SEC investigations of New Jersey, Florida,
California and elsewhere, which suggests that many states may be
papering over their fiscal troubles by providing fraudulent
information about their finances to muni-bond investors. The states
do this in a variety of ways, including keeping liabilities under
wrap through delayed filings or by burying them in opaque documents.
They also may resort to deferring payments of obligations and
re-characterizing bond debt as revenues.
Despite such warnings, "Illinois plans to borrow more than $3 billion to pay the bills for FY2011 and, in June 2010, the legislature permitted the university systems to borrow millions more to make up for the fact that the state has not made the payments it had promised them." In other words, Illinois is not only borrowing more to pay its own bills (by floating bonds) but it also has begun allowing other entities within its purview the new privilege of borrowing as a means of helping that entity to meet the state's portion of obligations to it. This according to the non-profit Sunshine Review, which is a collaborative research organization dedicated to state and local government transparency.
The Sunshine Review further reports that: "As of the end of August 2010, Illinois had borrowed $9.6 billion in the prior 12 months." For Illinois residents this means that as much as $551.3 million extra will have to be shelled out for the state's borrowing over the last year alone. In addition, "more than half the state's additional borrowing costs, amounting to approximately $301.2 million, will come due in the next five years." And adding still more salt to taxpayer wounds, "the cost of insuring five-year Illinois bonds to protect $10 million of debt against default in June 2010 rose to $370,000, a record, from a low of $155,000 in January, 2010. The price fell back to $281,000 at the end of July 2010."
In
addition to the myriad problems associated with borrowing to pay
obligations (about which we have only touched upon here), there is
another problem connected to the budgetary process -- and it lies in
current accounting practices which rely on the cash basis method
(also referred to as modified accrual basis). This according to the
Institute
for Truth in Accounting,
a professional group of financial and public policy experts dedicated
to reform of the GAAP accounting practices now used under the
Comprehensive Annual Financial Reports (or CAFRs). For example, "the
state of Illinois routinely delays Medicaid payments to healthcare
providers. Each year the budget appears balanced on a cash basis even
though the state does not provide sufficient funding for the Medicaid
program."
While
arguing that "objectively better" accounting systems are
universally employed in the private sector, the IFTA said that its
research found that the current accounting system "does not give
all stakeholders an accurate diagnosis of the financial health of
state governments because the accounting principles recommended are
biased towards the interests of government officials. The current
structure and funding mechanism of the GASB make it difficult for
members of this board to not be influenced by constituency groups
that represent governmental officials and their staff."
Thus,
says former
SEC Chairman Arthur Levitt,
"At the core of the [muni] problem are questions about how
governments manage pension funds, what investors know, and when they
know it. The case against New Jersey revealed that the state has made
unfunded pension fund promises to its employees, and compounded the
problem by not being forthright with bond investors."
In
ideal circumstances, pension funds are supposed to keep up with
benefit promises through a combination of employer and worker
contributions, together with market returns from a fund's investment
portfolio. But, says Levitt, those revenue streams have slowed to a
trickle as states have cut back on their own contributions, employees
have contributed too little, and hoped-for investment gains have
shriveled up. If investors discover that the muni market has instead
become a way to paper over irresponsible promises, they will flee it,
and that could spell disaster.
Investor
anxiety has become significant enough that "some
analysts
have suggested
that the Fed could ease muni-market worries by purchasing muni debt
or lending to struggling borrowers." But on January 7, Bernancke nixed the idea on legal, political and practical
grounds, saying "that if municipal defaults did become a problem,
it would be in Congress's hands, not his."
But
assuming that Congress will bail
out
any
state in terminal trouble is itself a very risky gamble. Why? Because
"[a]nything that the feds do for one state they'd have to do
for others, which would turn into a bottomless and politicized
spending pit." With balance-sheet problems of its own to contend
with, the federal government is hardly in a position to bail out a
string of troubled states, and this fact is being reinforced by growing
taxpayer objections.
All
of which brings us back to the unchartered waters of quantitative
easing. Will QE2 and beyond be able to provide the kind of economic
relief so desperately needed by Main Street? This is likely to remain
an open question for some time to come because the money spigot used
by the Fed can only create money as bank credit -- and credit becomes
far more expensive, indeed sometimes altogether unobtainable -- for
those in financial distress. Which of course translates to a "tight"
money (as credit) supply right where it is needed most -- here on Main
Street.
Should
QE2 (or maybe 3 or 4) somehow ultimately work well enough to satisfy
squeaky wheels, there's still that pesky question forever lurking in
the background: Can we REALLY keep borrowing our way into prosperity?
Or is there a better way? [2] [3]
Notes:
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