‘Defaults Will Outstrip Bankruptcies,’ Economist Says

‘Defaults Will Outstrip Bankruptcies,’ Economist Says
October 30, 2012

The federal and state governments may receive most of the attention for what are widely acknowledged to be unsustainable fiscal policies, but local governments also have unsustainable policies of their own.

A three-person panel detailed the scope of the local government problems during an October 22 discussion at DePaul University in Chicago.

“Defaults will outstrip bankruptcies,” declared panel participant James Estes, a professor of finance at California State University-San Bernardino, setting the tone for much of the discussion. San Bernardino filed for bankruptcy in 2012.

Titled “The Public Sector ‘Bankruptcy’ Crisis,” the event co-hosted by DePaul University and the Institute for Truth in Accounting featured as keynote speakers Estes; Bridget Gainer, a commissioner of Cook County, Illinois; and Sean McShea, president of Ryan Labs Asset Management, which manages fixed-income portfolios for institutional investors.

Poor Accounting Standards

Dodgy government financial reporting standards have enabled tens of thousands of municipal and county governments and local special taxing districts to hide their true financial condition from most local residents, said Sheila Weinberg, founder and CEO of the Institute for Truth in Accounting. Weinberg moderated the panel discussion.

Forty-nine of the 50 states have balanced budget requirements—requirements that in many instances are all but meaningless, Weinberg noted, arguing that accepted accounting practices undermine these laws.

She noted most of the rising costs of unfunded off-balance-sheet retirement obligations are not included in the ‘expenditures’ reported in municipal income statements, allowing governments to flout the intent of balanced budget laws. 

This was demonstrated in California this year, where several municipalities have filed for bankruptcy, including San Bernardino and Stockton.

Estes criticized efforts to excuse the local government crises by claiming “we couldn’t have known this was coming.” He said the problems were indeed foreseeable to those who were not beholden to local government “cronyism” or wrapped up in “bubble” psychology.

Estes said he expects defaults despite difficult legal impediments such as disputes over the intersection of federal and state laws.

New, Risky Option

He also warned about the growing use of a financial instrument that some municipal issuers have viewed as an attractive solution for their current problems: capital appreciation bonds.

Capital appreciation bonds are issued at deep discounts, like zero-coupon bonds, but their return is driven by compounded interest rather than recovery of the original discount. This allows the original issue amount, not the ultimate par (redemption) value, to be counted against statutory debt limits.

Estes said the high yields and lack of funds to support payouts make them particularly risky, not only for buyers but also for taxpayers, who could face higher costs to pay for them.

Collapsing Funding Ratio

Gainer provided an inside look at the problems as a Commissioner of Cook County, which includes the Chicago metropolitan area. Gainer led other commissioners in adding a pension committee to the County Board in 2009. Cook County has more than 23,000 employees and 15,000 retirees receiving retirement benefits from the county. Since 2000, the funding ratio for the county’s pension system has fallen from 90 percent to just 57 percent in the latest estimates.

Gainer said health care costs in Cook County government are nearly $14,000 per employee. This is much higher than several peer comparisons and roughly 40 percent higher than the U.S. private-sector average.

Looking at the difficult trade-offs ahead, Gainer said employees and retirees may have to accept higher costs and lower benefits in their health care plans in return for greater stability in their pension plans. Adjustments to cost-of-living protection and a higher retirement age could also be part of a solution.

“It’s about choosing which hill you want to die on,” Gainer said in providing a metaphor for the choices municipal leaders face in dealing with their local governments’ financial woes. These difficult choices will affect various constituencies, including bondholders and the asset managers representing them, she said. 

‘Principal-Agent Problem’

Sean McShea characterized the issue as a “principal-agent problem.” The principals include retirement plan participants, bondholders, and current and future taxpayers. They have been represented or influenced by a wide variety of “agents” and other parties including ratings agencies, consultants, and politicians.

McShea said that until recently public financial planning meetings have been dominated by “agents talking to agents,” leaving the principals out of the process—and left with underfunded retirement plans.

Weinberg said municipal financial conditions can be better understood in the context of local economic and demographic characteristics, and she introduced IFTA’s new “State Data Lab” Web site, which provides some of that context.

For example, many people blame California’s financial troubles on the housing market collapse. The state-level home price indices computed by the Federal Housing Finance Agency show a 44 percent decline in California’s index from the early 2007 national peak to the bottom in early 2011. That decline ranks as the fourth-worst among the 50 states. 

But the other four states with the five worst declines do not show anywhere near the government fiscal strains evident in California. For example, the average rank for those four states (Nevada, Arizona, Florida, and Idaho) in terms of current taxpayer burden comes in at 36, while California ranks 7th worst in the nation in IFTA’s analysis. Reviewing all 50 states together, the severity of the 2007-2011 housing collapse has little relationship with state government fiscal strains when compared to other significant measures available on State Data Lab.

William Bergman (wjbergman@sbcglobal.net) is an economist who writes from Chicago.

Internet Info

Institute for Accounting's State Data Lab:www.statedatalab.org.