March 8, 2011

Your Legacy: Will Your Heirs Pay for State or Local Debt?

Finally, there is a voice of reason regarding the dire stress faced by state and local governments in the U.S. In crying that states are "Broke," governors fail to mention that state and local governments have been ignoring pension liabilities for years, and it isn't teachers’ individual pensions that are the primary culprits although they seem to be getting the lion's share of the blame. Remember—these pensions typically go to those with moderate- or lower-paying jobs; the pension was factored into the equation because of that.

That blame rightly belongs to cronies of state and local politicos who often get plum jobs and pull in pensions that are much larger than most teachers ever will. I am not saying every municipality is thus, but the fact that elections mean officials are temporary stewards of state and local funding tended to lead to an attitude of  ‘Let the next (governor, mayor, council) fix the pension problem.’ And all the while pension liabilities, inadequately funded piled up.

An editorial, “The Hollow Cry of ‘Broke’,” in The New York Times on March 2 noted that, “Though it may disappoint many conservatives, there will be no federal or state bankruptcies.”

There won't be a cascade of state defaults. That makes sense to this former muni trader and underwriter. Here’s why: State and local municipalities sell their "general obligation" (GO) bonds at low yields favorable to taxpayers because the costs are low and to buyers because the interest is tax exempt. Under normal conditions GO bonds of states and municipalities that are investment grade are/were considered second only to U.S. Treasury securities in safety, and long-, medium- and short-term GO munis were scooped up by, well, institutional investors, insurance companies and very conservative individual investors. Back in the Stone Age before the repeal of Glass-Steagall, banks could only underwrite GO bonds.

Full Faith and Taxing Power

Why? Because they are backed by covenants that say that these general obligations are backed by the full faith and taxing power of the state or municipality. In other words, states are supposed to raise taxes, if necessary, to pay off the bonds. That's the other reason yields are low, because the risk was considered to be ultra low.

If states are allowed to go bankrupt and default on these GO bonds, how will they finance necessary municipal debt? If states and municipalities want to need to borrow after that, it would cost taxpayers much more in interest. As much as it may pain politicians now, they need to remember that:

These pension liabilities built up over many, many years. While it is good to finally address them—and it will be even better to have transparency for investors as we go forward—there will be no instant fix here.

GO munis will have to be paid off, by raising taxes, if necessary.

As a nation, we need to a multi-year plan to address these issues, but balancing state budgets cannot be addressed by municipal default.

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