Bankrupt, USA: Why Our Cities Aren't Too Big To Fail

¹²Meredith Whitney's New Target: The States

The housing crash not yet realized its full impact on budgets in the most vulnerable states. It's the banking crisis all over again— and it's time to stop ignoring it. Meredith Whitney, the superstar analyst who famously forecast disaster for America's big banks before the credit crisis struck, is now warning about another looming threat: The wreckage from over-stretched state budgets.

By Shawn Tully | 28 September 2010

Today, Whitney is releasing a 600-page report, colorfully entitled "The Tragedy of the Commons," that rates the financial condition of America's 15 largest states, measured by their GDP. Whitney claims that the study is the most comprehensive, in-depth analysis of the states' murky patterns of spending, revenues and benefits programs ever assembled by the government, foundations, or another research firm. What Whitney found reminds her of the poor disclosure and arcane accounting rules that hid the fragile condition of the banks and monoline insurers that she unmasked.

"The states represent the new systemic risk to financial markets," says Whitney. "I see a lack of transparency and an abundance of complacency on the part of investors and politicians, just as we saw before the banks imploded. "The similarities between the states and the banks are extreme to the extent that states have been spending dramatically and are leveraged dramatically. Municipal debt has doubled since 2000, spending has grown way faster than revenues."

Whitney also offered another warning about banks, saying a sharp dropoff in trading revenue and a double-dip in housing would hammer at fourth-quarter earnings. Whitney reiterated her call that some 80,000 financial services jobs will be lost this year, based on an expected 25 percent sequential decline in equity trading and "low single-digit" returns on equity. On top of that, she said housing numbers will begin to worsen. The monthly Standard & Poor's/Case-Shiller housing report earlier in the day signaled that home prices were flattening but stabilizing; Whitney said that that reading is going to get progressively worse.

"This quarter is going to be unique for the banks because this will be the last quarter when they can dodge the credit bullet," she said. "We think October, after the banks report, you'll see a really ugly Case-Shiller number, which means the fourth quarter is going to be very tough for banks."

The study represents a departure for Whitney, whose boutique research firm specializes in providing its clients, including hedge funds, big institutions and banks, with proprietary research on the financial condition of consumers, ranging from projections on credit card defaults to regional employment trends. So why the mega-work on the states?

"It's not that my clients requested it," says Whitney. "I was just so shocked by what I was seeing that I couldn't stop. Any long-term strategic plan needs to take account of the dangerous, mostly overlooked problems in the state finances. It reminded me so much of the banks pre-crisis that we just kept working at it. We couldn't find anything that gave us a clear story, we couldn't find any information that was transparent. So we did it ourselves."

The title, "The Tragedy of the Commons," comes from a parable about greedy farmers who let their sheep gobble up all the grass in a [community commons] pasture, leaving the land barren and unfarmable— reflecting the spending frenzy that promises to decimate the prospects for many of America's largest, and formerly most prosperous, states. In the report, Whitney rates fifteen states on four criteria, their economy, fiscal health, housing, and taxes. For each category, she assigns a rating of one, two or three for best, neutral or negative.

Only two states get positive overall ratings: Texas and Virginia. Eight are either negative, or rated neutral, with a negative bias. The rub is that those are typically the states with the biggest economies: California, Ohio, New Jersey, Michigan, and Illinois (all negative) and Florida, Georgia, and New York (neutral, negative bias).

The full rankings:

Worst states

1. California

2. New Jersey, Illinois, Ohio (tie)

3. Michigan

4. Georgia

5. New York

6. Florida

Best states

1. Texas

2. Virginia

3. Washington

4. North Carolina

Neutral states: Pennsylvania, Maryland, Massachusetts

Put simply, the study warns that the giant gap between states' spending and their tax revenues, estimated at $192 billion or 27% of their total budgets for the 2010 fiscal year, presents two dangers that investors are seriously underestimating. First, municipalities could start defaulting on their bonds guaranteed by the cities and towns themselves, an exceedingly rare event over the past three, mostly prosperous, decades. "People keep saying it can't happen, just as they said national housing prices could never go down," says Whitney. "Now, it's a real danger."

The reason: the municipalities receive one-third of their revenue from the states. If the states hold back that money for their own stricken budgets, towns and cities won't have the funds to make their interest payments. "It has to happen," says Whitney. "The states will secure their own shortfalls, and leave the cities to fend for themselves". It's all about inter-dependency, she says, with the federal government aiding the states, and the states funding the last and most vulnerable link, the municipalities.

Meanwhile, the housing fallout continues. Second, Whitney sees the budget shortfalls as a far stronger leash on both employment growth and overall expansion than investors realize. The common thread between the banking and looming state financial crises, she says, is housing. "The entire financial system was over-leveraged to real estate," says Whitney. "So were the states."

During the boom years from 2000 to 2008, the states that grew the fastest were the ones where housing prices grew fastest, and where construction flourished, including California, Florida, New York, and New Jersey. In Florida, almost 30% of income growth came from real estate, an astoundingly high figure. Tax revenues soared during the real estate frenzy, and spending soared along with them. Now, revenues have collapsed with housing prices, and spending is proving far stickier. The legacy: Today's gigantic deficits.

Then, as housing prices fall, the states that grew the fastest and outperformed in the strong years, are now posting the worst economic performance— for the obvious reasons that they face the biggest mortgage delinquency and foreclosure rates, as well as high unemployment due to the collapse in construction and mortgage lending. The "haves," says Whitney, have suddenly evolved into the "have-nots."

The problem is that the states that benefited disproportionately from housing are generally the biggest economies, so their woes have become a deadweight on overall economic growth. "Other states such as Nebraska, even with larger ones like Texas, aren't large enough in total to offset the weak growth in the states that depended on real estate," says Whitney. What investors are missing, says Whitney, is that growth in those states is destined to remain feeble because of the drastic measures needed to redeem their finances.

By law, almost all states are required to balance their budgets. Right now, the Obama stimulus package is making up over $60 billion of the $192 billion shortfall for fiscal 2010. But that money is slated to disappear next year. States are already raising taxes, or planning to— voters in Washington will soon vote on a referendum to levy an income tax.

The biggest source of funds to fill the still-giant gaps is especially worrisome: Raiding pension and healthcare funds. States from California to New York are shifting contributions needed to pay workers' benefits in the future toward funding current expenses. The housing collapse will leave a different legacy by forcing big tax increases, and cutbacks in benefits including a rise in retirement ages.

Millionaires who provide a huge share of the revenues will leave the high tax states, leaving behind the poor who need most of the services. "The scary thing," says Whitney, "is that no one wants to talk about it. When you get the data and mechanics together the situation is as basic as it was for banks or consumers". "The Tragedy of the Commons" should get people talking, and the daunting scale of the numbers should get them outraged.

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¹²Bankrupt, USA: Why Our Cities Aren't Too Big To Fail

By Kit R. Roane | 15 September 2010

FORTUNE— Harrisburg, Pennsylvania, has dodged a debt bullet. The only problem is that the gun is still loaded. The Keystone State's cash-strapped capital was scheduled to default on a $3.3 million bond payment on Wednesday. It avoided that debilitating fate when Pennsylvania's governor, Ed Rendell, pledged to resolve the problem with $4.4 million from the state's own challenged coffers.

This gives Harrisburg a chance to fight again another day. But its problems are far from over, and that's bad news for investors in the $2.8 trillion muni-bond market. States from California to Illinois have been in deep crisis since the recession began, hammered by drastic cuts in tax revenue and inflexible spending demands for things like health care, debt service and pension plans. Forty-eight states grappled with fiscal shortfalls in their 2010 fiscal budgets. Totaling $200 billion, or 30% of state budgets, this fiscal shortfall is the largest gap on record, according to the DC-based Center on Budget and Policy Priorities, which sees at least 46 states facing shortfalls this fiscal year.

Some cities are in even worse shape than Harrisburg. Central Falls, Rhode Island, recently went into receivership when it couldn't pay its bills. San Diego is said to be considering bankruptcy to get out from under its pension obligations. Miami's city council, hoping to avoid Harrisburg's fate, recently used 'emergency' powers to slash city salaries and pensions and is now instituting hefty traffic fines and garbage fees.

This year, ratings agencies have cut the debt in several cities— including Littlefield, Tex., Detroit, Mich. and Bell, Calif.— to junk. Harrisburg's default on bond payments for its ill-fated $288 million incinerator project would have given it the dubious distinction of birthing the second-largest default on general-obligation municipal bonds this year. The largest default was on $227 in municipal warrants issued by Jefferson County, Alabama. Given that general obligation bonds are backed by the full faith— and taxing power— of the issuing government, and aren't supposed to default, even the hint of strain with such a bond is worrisome.

Buffett's prediction: Stiffing creditors

The growing perceived risk has sent a few municipal bond buyers in search of safer pastures. Warren Buffett's Berkshire Hathaway (BRK-A), which doubled its municipal bond holdings as investors fled the sector between June 2008 and March 2009, was more recently selling its municipal bond investments and moving to shorter maturities. The reversal followed Buffett's February 2009 investor's letter, where he noted that city councils were much more likely to skin bond insurers and bond investors than their own constituents.

He said the trend will begin when "a few communities stiff their creditors and get away with it." His municipal bond insurer, Berkshire Hathaway Assurance Corporation, also quickly pulled back from the market that year, insuring less than 8% of the $600 million in municipal bonds it guaranteed in 2008. The problem, he told the US Financial Crisis Inquiry Commission this June, is that nobody really knows what state and major city municipal bonds are worth. Calling the municipal debt market "troubled," he opined: "If the federal government will step into help them, they're triple-A. If the federal government won't step in to help them, who knows what they are?"

Many participants in the municipal bond market, which is made up of more than 50,000 different issuers and more than 1.5 million issues, see concerns like those voiced by Buffett as overblown. After all, most states are likely "too big to fail" in the federal government's eyes. And, no matter how you slice it, defaults have remained exceedingly rare over the last thirty years.

According to Moody's, the ten-year default rate for investment-grade municipal bonds in recent decades has hovered around six-tenths of a percent. Dominic Frederico, the CEO of Assured Guaranty (AGO), a bond insurer, told attendees at an investment conference last week he calculates there have been only 60 municipal bond defaults through August 2 and that most of these defaults were not investment grade. The numbers, he said, show no evidence of a crisis at hand.

Defaults On The Rise

That's just the sort of data that has kept a multitude of yield-hungry and tax-averse investors flocking to the sector. In August, investors plowed more than $1.2 billion a week into municipal bond funds. They invested a record $69 billion in new money there in 2009, up from just $7.8 billion in 2008 according to the Investment Company Institute. High-yield— or "junk"— bonds have been exceedingly popular too.

But defaults on municipal debt have been rising, according to the Distressed Debt Securities newsletter, which says defaults rose from $349 million in 2007 to $7.77 billion in 2008. They have breached $4 billion so far this year, according to Bloomberg, despite heavy stimulus injections and other dollops of federal aid. Also, while AAA-rated bonds rarely go down the drain, the more speculative grades don't always stand up so well, with bonds rated B to C having ten-year cumulative default rates of 11% to 13% even in good times.

Municipal bond defaults could continue to rise even if the economy gains a footing. According to the US Government Accountability Office, despite the federal help, state and local governments continue to operate in the red. Without massive austerity, the GAO predicts their fiscal positions will continue to worsen for the next fifty years.

The problem is that the vast majority of municipal bond investors these days tend to be of the mom and pop variety and they are not generally being compensated much for risk. As Bond Buyer notes, heavy investor demand last month pushed "10-year tax-exempt yields below 2.20% and 30-year munis lower than 3.70% for the first time in history". Despite the Pollyannaish view expressed by such a yield, critics fear that you don't need another Panic of 1873— when ten states, including Alabama, Arkansas, Tennessee, Michigan and Minnesota, defaulted on their municipal debts— to seize up the system.

Drop Dead

Perhaps not even something like the famed default of New York City during the Gerald Ford administration in 1975 would be needed to instigate a panic. Rapidly rising interest rates would be enough to wipe the smile off many retail investors in muni-bond funds. A few smaller but well-known municipalities threatening default could send them fleeing for crowded exits.

And crowded they would be. Despite the liquidity of municipal bond mutual funds and ETFs, their underlying bond holdings trade far less often. The "new normal" hasn't helped matters, noted bond giant Pimco this January, explaining that many of the major broker dealers in the municipal space— Bear Sterns and Lehman Brothers for instance— are no longer with us, while many of the major liquidity providers there, such as single strategy municipal hedge funds, "collapsed or were shut down."

Nor is a wave of defaults off the table just because they have not occurred in recent decades. Before the housing downturn, real-estate bulls saw housing prices laddering to the sky and often noted that real-estate prices had never declined nationwide— until they finally did. As Richard Bookstaber, the senior policy advisor at the Securities and Exchange Commission wrote in a blog post this April, the municipal market is massive, leveraged and opaque, blessed by questionable analyst ratings and backed by revenues already mortgaged off to someone else.

In other words, it bears all the hallmarks of a crisis in waiting.