States & Cities At Risk: Including New York

Posted by jeff

Wed Mar 12th, 2008 09:53 AM

State%20Cap.jpgWhile many see the machinations on Wall Street as distinctly separate from the day-to-day realities of the real world, the worries or passions that are reflected in securities market moves are based on reality and market participants' concerns and hopes about future trends. Sometimes markets get it wrong and worry far too much about potential future outcomes, or put too much stock in them. Sometimes markets seem prescient and sniff out a new trend before Main Street has any clue it's coming. Rarely, but once in a while, market moves actually drive trends that are normally the impetus for price moves in those markets. We are in one of those strange times, when because of all the leverage in our economy, the tail is wagging the dog. (See my recent piece,The Mother of all Margin Calls)

In recent weeks, the municipal bond market has come under severe pressure due to the capital adequacy problems with monoline insurance companies (see my piece, Tentacles of the Credit Beast) , which insure municipal debt. As many have pointed out, municipal debt has performed very admirably over time, with low default rates. In fact, some municipalities are now wondering, why they ever used the insurance in the first place. However, fear over the efficacy of insurance on products that never really needed insurance, should not cause the kind of huge re-rating of municipal bond risk that it has in the market. According to the Financial Times:

Yields in the US municipal bond market have soared to historically high levels compared with US Treasury bonds, as investors respond to uncertainty over the fate of bond insurers and Wall Street banks withdraw support from the market.

This kind of move does not happen solely because of some arcane issues with bond insurance. Yes, I know that there are many investors who must sell bonds if they don't carry better than a particular credit rating. However, some investment committees can take short-term exigencies into account and override these rules. Additionally, other investors would come in to buy up bonds that those committees that can't flex their guidelines force their portfolio managers to sell, if this were the only issue. Note that smart guys like Bill Gross of Pimco and Wilbur Ross of W.L. Ross have been doing just that, but spreads would never have gotten to record levels if there wasn't some underlying increase in credit risk to these instruments.

So whatup with muni bonds? It's the economy stupid! As I noted in my 8 Predictions for 08, the real estate debacle is hurting state and municipal finances. By my count 16 states were already having budget issues coming into 2008, and I missed New Jersey, which is busy whacking its spending (Sopranos style) and contemplating big job cuts. Collection of real estate taxes and transfer taxes on real estate transactions are down. But revenue is now being further attenuated by falling sales taxes and eventually income taxes. In the meantime, home foreclosures are adding to the need for state-provided services of various kinds. According to Financial Week:

Twenty-one states face budget deficits in fiscal 2009, including 16 that are short at least a combined $30 billion, according to the Center on Budget and Policy Priorities.

These fiscal issues are also impacting cities, abetted by a trickle down impact of a lack of state funds. According to Reuters:
Revenues in one-third of American cities have declined over the past year because of a rise in housing foreclosures, the National League of Cities said in a report released Tuesday. Nearly two-thirds of the more than 200 cities participating in the poll said they have seen foreclosures rise, leading one out of three to cut funding for community programs. The cities are also grappling with growing demands for food banks and counseling, the report said.

Across the northern states, snowstorms have posed budget problems for cities from Milwaukee to Rochester to Wareham, Massachusetts. If these cities can't handle a little extra snow, imagine what's going to happen when the heavy stuff starts coming down. Margins for error in state and municipal finances are thin, because rapidly rising revenue allowed budgets and services to expand even as costs were spiraling upwards. Now that revenues are flagging, healthcare costs, fuel costs , pension costs and construction and maintenance costs are biting hard.

As I noted in my predictions for 2008, "state spending is $1.8 trillion annually and reportedly about 13% of the economy and state spending is going from a big booster of growth to potentially contracting." I think we can safely add municipal spending to the category of areas of the economy likely to disappoint. In some cases the disappointment could be large - for example Vallejo California, which recently narrowly averted bankruptcy. Of course, Vallejo, which has had problems since before subprime was put in the dictionary, and Jefferson County, Alabama (currently caught in a derivatives debacle) were in Warren Buffet parlance, "skinny dipping", before the credit crunch. But of course you only find out who is skinny dipping when the tide goes out and the tide is definitely going out on state and municipal government finances.

Please note that New York State and Gotham City are not immune. The State has an estimated budget deficit of $4.7 billion, but the news on New York City has been pretty good so far. The Independent Budget Office's annual report just came out and in testimony to the City Council, Ronnie Lowenstein had this to say about the outlook this year:

While the local economic downturn and the declines in tax revenue have dimmed the city’s fiscal picture, our short-term budgetary condition may not be as dark as one might expect. One reason is that so far this fiscal year business tax collections have not declined as much as previously projected. In addition, despite Wall Street’s huge losses, bonuses barely declined, bolstering personal income tax withholdings.

She goes on to note that a significant surplus is still expected for this year and that this surplus will help to plug holes in the 2009 budget. A deficit is expected to be forestalled until 2010, and the shortfall in that year is being estimated at a relatively modest $2.1 billion. Please note that these forecasts are based on the assumption of a relatively brief and mild recession. Among other areas where the outlook could go wrong are second order effects. According to the testimony:

There are a number of other potential fault lines for the 2009 budget and January Financial Plan.
For example, the Mayor’s budget plan does not recognize the effects on the city of the
Governor’s proposed budget. Another example is the planned conversion of a merged GHI and
HIP to a for-profit insurer, which could cost the city $200 million or more a year in additional
health insurance premiums for employees. A third example is stock market losses by municipal
pension funds, which may force the city to substantially increase its annual contributions to the
funds in the coming years.

The moral of this story is that major dislocations in financial markets, like muni bonds, don't happen on a whim or just because of mechanical market issues. There is always some truth behind a major move. In this case the truth is that state and municipal finances will have a negative impact on the economy and joblessness, and ultimately will feed back into weaker real estate prices in some places. The second chapter of the liquidity crisis is upon us and we are now going to start seeing the second order effects of it. Hopefully, the Fed's latest moves to give the credit markets an angioplasty will get the money flowing again and ease the severity of these second order effects.

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