Meredith Whitney is concerned about the state of the states. She’s the financial analyst who rose to fame from obscurity after accurately predicting the meltdown of the banking industry three years ago. After two years of exhaustive research her New York based company, Meredith Whitney Advisory Group, recently released a report entitled A Tragedy of the Commons which assesses and rates the state of finances amongst the individual U.S. states. She sees the situation with the states today as parallel to that the banks were in before the crisis, and she’s warning of another massive taxpayer funded bailout to come. Based on the information uncovered during the investigation Whitney is now warning of systemic problems that may lead to crisis in the municipal bond market and the risk of state default. The states are highly leveraged to the housing market due to their dependence on tax revenue, and just as Whitney predicted months ago it is now evident the housing market is indeed heading into a double dip. This implies, of course, that tax revenues will continue to shrink and place additional stress on the balance sheets of state budgets.
Basically, states are currently spending 27% more than they are earning in taxes. Municipal debt has doubled since 2000. State spending from 2000 to 2008 grew 60% while revenue grew 45%. For the fiscal year of 2011, the gap in state budgets stands at $121 billion and the total could exceed $200B without Federal help. States constitutionally have to maintain balanced budgets. They have used off-balance-sheet leverage and compensation schemes that borrow from the future, mostly in terms of raiding pensions, to create the illusion of balanced budgets. Whitney calls it “generational robbery.” Balanced budgets and abundant services get politicians reelected, and so that became the priority during the housing boom years when property values and high salaries were generating exponentially growing revenues. Hiring for state jobs and increased spending on local programs makes for powerful well-liked politicians… at least in the short run while the going remains good. Time has now run out on the sort of ponzi-structured approach it took to maintain the expenditures of such a plan.
It should be noted that not all the states are fairing badly according to Whitney’s report. Texas, Virginia, Washington and North Carolina are holding their own quite nicely. The states with the worst ratings are California, New Jersey, Illinois, Ohio, Michigan, Georgia, New York and Florida. California is by far the most precariously perched, by virtue of its sheer magnitude. It represents the world’s eighth largest economy if it is measured as a country, and it is highly exposed to the housing market with very few resources left to pull funding from. Some states like Florida are in worse shape in terms of foreclosure problems, but Florida has the option to implement an income tax to help counter any further losses in property tax revenue. California has already played all its cards and is in a very tenuous position. It already has an income tax. Its sales tax is one of the highest in the country. The legislature already took a twenty percent pay cut some time ago. The option to legalize, industrialize and tax its largest cash crop- marijuana- failed at the polls. There may not be a lot of options left besides making further cuts to government spending, privatizing services and restructuring pension funds. Raising taxes is a limited option in a state with a 12.4% unemployment rate, twice that number in underemployed, and a tanking housing market. Additionally and of major importance, California has already completely raided its pension system funds. Whitney predicts California and likely the other worst rated states in the report will soon be facing the risk of default.
Can a state default? Will California face bankruptcy? Legally, no. In California bondholders are constitutionally guaranteed payment. Only public schools have greater priority in their claim to state treasury funds. Public pension funds are also guaranteed. States cannot default on their debt technically, but effectively that is in fact the risk we are facing because there is just no money there. Legally, US taxpayers are required to make up for any shortfall in pension funds. Legally, everyone’s going to be required to pay higher taxes to compensate for budgetary shortfalls amongst the failing states. That is what we’re up against. This will not be an easy solution to implement, however. It may not even be viable. Citizens in fiscally conservative states like Texas who’s austerity and responsible spending got them through the crisis relatively unscathed are probably not going to be too happy about paying higher taxes to cover the tab for what they view as irresponsible spending sprees in California and the like. That would be a difficult move politically.
Beyond taxing the people, the government will look at the possibility of cutting spending. This will come down to cutting back and eliminating services. The main problem with this is that it will destroy jobs and lead to higher unemployment, which would be very dangerous to the health of the greater economy. The country is already seeing the worst unemployment situation since The Great Depression. California is currently at a 12.4% unemployment rate. What will happen if that rises? There is no easy solution here. Also, implementing cuts to government services and jobs will be strongly resisted by unions and labor advocate groups. Again, this may not be politically viable.
States are protected by a Federal safety net, so the real pressure will fall on local towns. Risk is not with the state debt service. It is with the local municipal debt service and cities. Expect to see damage there. A third of local municipal funding comes from the states. When a state gets into trouble it will protect itself and neglect the municipalities. Support of the municipalities will be compromised. The northern California city Vallejo actually declared bankruptcy two years ago when the cost of police and firefighters soared while the housing slump cut into tax revenue. Cities in California, New Jersey and other hard hit states have dismantled whole police departments in favor of contracting out to neighboring cities at less of an expense. These are the kinds of situations we can expect to see more of as well as a possible crisis in the municipal bonds market and further stress in regional banking.
In an op-ed piece published in the Wall Street Journal in early November, following the release of her latest report, Meredith Whitney revealed she had uncovered information showing the bailouts of states have actually already begun. The first attempt at creating a solution to the problem was to sidestep altogether the issues of raising taxes and cutting spending, and avoid at all costs calling the effort a bailout.
“Over 20% of California’s debt issuance during 2009 and over 30% of its debt issuance in 2010 to date has been subsidized by the federal government in a program known as Build America Bonds,” she wrote. “Under the program, the U.S. Treasury covers 35% of the interest paid by the bonds. Arguably, without this program the interest cost of bonds for some states would have reached prohibitive levels. California is not alone. Over 30% of Illinois’s debt and over 40% of Nevada’s debt issued since 2009 has also been subsidized with these bonds. These states might have already reached some type of tipping point had the federal program not been in place.”
But of course! Lure rich investors with subsidized profits! Clever, clever. Most subversive. So, Wall Street secretly saves the day. Those guys are like heroes. You know, now that’s why they get paid the big bucks. Uh, for now that is… can’t get into it right here, but Ms. Whitney also predicts a huge number of layoffs in the financial sector next year. Hush, hush… (Of course, the bill on those interest subsidies lands on the tax payer, as usual, so go ahead and give yourself a pat on the back and a big fat holiday bonus too!)
The Build America Bonds are not enough, though. The government is just kicking the can down the road and buying time on making the hard decisions necessary to turn this thing around. Meredith Whitney finds the level of complacency around the issue alarming.
“Most assume,” she continues, “that the federal government will simply come to the rescue of the states, without appreciating the immensity of the cumulative state-budget gaps. I expect multiple municipal defaults to trigger indiscriminate selling, which will prompt a federal response. Solutions attempted in piecemeal fashion, as we’ve seen thus far, would amount to constantly putting out recurring fires.”
Whitney suggests states need to take responsibility now and come up with the hard solutions. As a resident of California I can say I am skeptical at best that this will be the plan of action in the hardest hit of states, if past experience is any indication of what’s likely to come. The budget continues to be based on outdated revenue statistics and balanced by sucking imaginary revenue from the future. Of course this is not sustainable, but I imagine the California can will be kicked till it hits some sort of rock or a hard place. Perhaps the other states in trouble will take a more reasonable approach.
Meredith Whitney Interview on State Finances (Video)
September 30, 2010
The Wall Street Journal
State Bailouts? They’ve Already Begun.
November 3, 2010
States Are Poised to Be Next Credit Crisis for US: Whitney
September 28, 2010
Los Angeles Times
Maywood to lay off all city employees, dismantle Police Department
June 22, 2010
Vallejo, California, Plan to File For Bankruptcy
Michael B. Marois
May 7, 2008