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How Scary Are Municipal Finances?

Not as scary as you think, but scary enough to be picky.

Miriam Sjoblom, 08/26/2010

You don't have to look hard to find a reason to worry about municipal finances these days. Reports of a looming day of reckoning in the municipal-bond market from a wide array of commentators are ubiquitous. Former Los Angeles mayor Richard Riordan took to the Wall Street Journal's editorial pages to predict that the country's second-largest city would declare bankruptcy before 2014. Testifying before the Financial Crisis Inquiry Commission in June, Warren Buffett sounded alarms about the "terrible" financial distress facing many state and local governments in coming years. Buffett's muni insurer, Berkshire Hathaway Assurance Corp., has scaled back its activity substantially, guaranteeing only $40 million worth of muni bonds in 2009 compared with nearly $600 million the year before.

Given the severity of the Great Recession compared with prior downturns and the tenuous nature of the recovery, there's little comfort in the argument that muni defaults will remain rare just because they always have. But even though state and local governments continue to struggle through the worst economic climate in decades, many of the specific concerns getting attention in the media appear overblown. Some of the worst news stories involve isolated municipalities that made reckless moves well before the downturn, and many muni researchers can and did anticipate their troubles in advance.

Highlighting the Obvious
Dire straits in Harrisburg, Pa., have made headlines lately, but the foundation for its current predicament was laid back in the early 1990s, when the city agreed to guarantee the debt of an incinerator plant that had been plagued with problems since the 1970s, when it was built. The plant was already burdened with close to $100 million in debt when the Federal government shut it down in 2003 for polluting. At that point, Harrisburg borrowed another $125 million to rebuild it, hoping that it would make enough money collecting trash to eventually pay down the debt. Those revenue projections were far too rosy, however, and now the plant is saddled with almost $300 million in debt that it can't afford to pay off, leaving Harrisburg on the hook. Unfortunately, the $68 million due on the plant's debt this year alone exceeds the city's annual budget by $3 million.

Even though the incinerator plant has created a huge mess for Harrisburg, bondholders may still come out all right. Much of the debt is also backed by surrounding Dauphin County and/or insured by Assured Guaranty AGO, the last monoline insurer in strong-enough financial condition to continue backing new bonds. So far, Assured Guaranty has paid principal and interest on bonds with depleted debt service reserves that the county doesn't back.PAGEBREAK

The Las Vegas Monorail's Chapter 11 bankruptcy petition at the start of 2010 is hardly shocking, either. In a court filing, Las Vegas Monorail Corporation CEO Curtis Myles framed the bankruptcy as a result of the downturn when he indicated that ridership "has not met projections formed prior to the economic collapse." It didn't take a decline in gaming revenues to drag the project under, however. The monorail never came close to reaching the ridership and revenue projections laid out by consultant URS Greiner from the outset. The company projected fare revenue of $50 million in 2005, a target the monorail missed by $20 million. Actual fare revenue hovered around $30 million each year even though initial projections estimated revenue exceeding $60 million in 2009, a target it missed by more than half. Since payments on the debt depended on net revenue left over after operating expenses, muni analysts didn't need to be rocket scientists to see the writing on the wall.

Deficit Crisis, Not a Debt Crisis
For those concerned about a replay of the eurozone's sovereign debt crisis among municipal issuers here at home, the numbers don't add up. State debt burdens, which range from 0% to 7% of gross state product, are still low, and annual debt service as a percentage of budget expenditures ranges from 0% to 13%, or roughly 3% on average, according to the Bureau of Economic Analysis. State lawmakers in California have yet to close a $19 billion budget gap for the current fiscal year, but that doesn't mean its general-obligation bonds are in danger. The state's estimated debt-service payments this year amount to roughly 5% of its budget and rank second only to spending on education. Payments on California's general-obligation bonds are also continuously appropriated, meaning they'll get paid whether lawmakers agree on a budget or not. Sacramento has already demonstrated a willingness to take drastic measures--whether furloughing workers or issuing IOUs--to keep enough cash on hand.

Granted, the numbers look worse if you add in states' unfunded pension obligations. That threat is more long-term than immediate, though, and some states have begun taking the necessary steps toward addressing the shortfall. New York recently modified rules requiring new employees to make annual pension contributions of 3%, for instance. Several unions in California acceded to benefits cuts for the first time in years, and unions in other states have also supported benefits cuts and increased contributions from new workers.

Some commentators have expressed concern that a few state and local governments will lack the political will to make the tough decisions required to balance their budgets and pay off their debt. That hasn't been the case, by and large. State tax revenues are still well below pre-recession levels, but the gap between current tax receipts and expenditures for states and local governments has narrowed considerably over the past two years partly as a result of both service cuts and tax increases, including "sin taxes" on alcohol, tobacco, and gambling. According to Barclays Capital, at least 45 states have cut services to their residents this year while 30 have raised taxes.

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