State of the State for Muni Investors

Miriam Sjoblom: Hi. I'm Miriam Sjoblom, associate director of fund analysis at Morningstar, and I'm here at the Morningstar Investment Conference with the municipal bond manager at AllianceBernstein, Michael Brooks. Thanks for joining us, Michael.

Michael Brooks: My pleasure.

Sjoblom: Well, there has been a lot of concerns over the past year in the headlines about credit risk in the municipal bond market. Can you talk to us a little bit about how states and local governments are doing at balancing their budget in this very difficult economic environment that they have been in?

Brooks: Well, states, in particular, let's focus on states at first. States have had a difficult time. Tax revenues of states took a gigantic drop. They reached a peak in September of 2008, which by the way was the month that Lehman Brothers filed for bankruptcy, and from that point through the next five quarters they dropped by $97 billion. That was the biggest drop that we have ever seen. That resulted in gigantic budget gaps across the nation, and if you were to add up in fiscal year 2010 all of the state budget gaps, you're going to come to a number of about $191 billion. That's on a base of about $725 billion. That's an average budget gap of a state of 26%. That's enormous. Some of those states were 40%, others were much smaller, but an average of 26%--that's an unprecedented number.

The federal government came in and picked up about a third of those budget gaps, but that money is going to disappear in fiscal year 2012. They are only getting $6 billion. So the question then becomes, if the budget gaps did not decline, then the state share is going to increase dramatically, but the budget gaps actually have declined dramatically, largely because tax revenues have improved. State tax revenues are now not back to where they were, but they're halfway back to where they were from that big gigantic drop. And states are taking actions to fix the problems. I mean, it's painful, they have to lay off people, they're putting people on furloughs, they're cutting aid to localities, they're raising taxes, they're doing a variety of things. But the size of the budget gaps have shrunk, and therefore, the amount that the states are going to have to deal with in fiscal year 2012 is actually a tiny bit smaller than it was in 2011, and that's a good trend, and that will continue, I believe, going forward.

Sjoblom: We've seen lately some signs of slower growth, some kind of discouraging signs about the economy. So, even though you're seeing improvements, are we still in a really challenging period?

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Brooks: Well, you're clearly in a challenging period. If you look at the growth of state and local tax revenues, and you compare that to nominal GDP, national GDP, you'll find that those two charts, if you put them one on top of the other, there is an incredible correlation between the two.

When nominal GDP took a sharp drop negative, tax revenues took a sharp drop negative. Now, the question is, what's going to happen with the U.S. economy? If we have negative nominal GDP again, then the states are in real trouble, but I don't think ... our economists are not really seeing that. Hopefully, this will be a little slower recovery than we had anticipated, and we are not going to go into another deep dip recession again.

Sjoblom: I guess if the worse did happen, how likely is it still that one of these states might not make good on its debt obligations?

Brooks: Well, I don't believe that any state is going to default on its debt. ... Default, in my mind, means they don't pay interest on principal on time or in full.

Illinois, for example, which is sort of the worst state in terms of its finances in the nation, even worse than California. It's extremely difficult, you might say impossible, for it to default. In the state constitution, the state treasurer is obligated on a monthly basis to take the first available revenues and scoop them out, and put them into a special debt service fund 12 months in advance of when that money is needed. So if you have a principal payment that's due 12 months from now on a general obligation of the State of Illinois, that money is already sitting in that fund, and the legislature can't get its hands on that money, and the governor can't get his hands on that money, and every month the state treasurer is obligated under the state constitution to pull out the first available revenues and stick it into that fund.

So how are they going to default on their debt? It's not likely, it's not possible, in my view. But that doesn't mean that they are not going to have serious fiscal difficulties, which they are. They've taken a big step to fix those by raising the income tax from 3% to 5%; that's worth about $6 billion, maybe a little bit more, but that's only about half the way through. They've got other problems that they have to deal with.

Sjoblom: A longer-term issue that's gotten a lot of attention is the pension liabilities that a lot of states have to deal with. You mentioned Illinois--that's a good example. How big a risk is this for bondholders?

Brooks: Well, in most places, pension obligations and OPEB, which is Other Post-Employment Benefits, largely health insurance for retirees, represent a long-term problem, a problem that for current investors is something in the distant future that you don't have to worry too much about.

But in other places, like in Illinois, it's a real problem and it's much more immediate. If Illinois doesn't fix its problem, it could run out of money in its pension in 10 years, so it has to deal with that, and that becomes a more immediate problem for bond investors.

Illinois is taking some steps here. They have funded their pension in the last couple of years, but they had to borrow the money to do it. That puts more pressure on their operating budget because in a pension when you have to make your contribution to that pension, you can be flexible. You have some freedom. You can say, "Well we don't really have the money this year. We'll make it up next year."

But with your debt service, with your payments of principal and interest, you have no such freedom. When that payment comes, you have to make it--you lose that flexibility. So it is clearly an issue in places like Illinois and other places like Puerto Rico and other places like that. So you have to look at that. You need research to understand what's going on and whether or not it makes sense to invest in those places.

Sjoblom: Are you seeing signs that for any of these states that have more challenging pension situation that they are taking steps to fix it?

Brooks: Most places are taking steps to fix it, but what they really need to do over the long term is they need to get out of the pension business. They've got to go to a defined contribution plan, 401(k)s, IRAs, corporate America has done that more than a decade ago. They've got to get out of this business.

I don't believe that they are going to be unable to find new workers if they do that. Now, they can't take the people who are already in the system, who have already been promised pensions, who are already working for the states--they can't say, "Well, we're going to turn you into a defined contribution plan," but it's only the new people that they can do that.

If they move in that direction, it will take some time to get over this, because this problem is not going to go away, but ultimately they are going to be a lot better off, and they have to find ways to get more money into that system, which means they are going to need greater contributions from their employees. That becomes a collective bargaining agreement, and so they have to have the political will to find a way to get their employees to agree to put more money into that system.

Sjoblom: Well, Michael, thank you. Very interesting insights. Thanks for sharing them with us.

Brooks: It's my pleasure. Thank you very much.