On the Muni Debt Bomb

Meredith Whitney said 50 to 100 cities could default on their municipal debt bonds in the coming years. Time to pay attention. The predictor of Citigroup’s demise may not always be right, but her warning—on an 60 Minutes interview this weekend—should be enough to look into the situation. That is if you didn’t heed the warning from Steve Malanga last August.

So what’s the problem? Here’s how Malanga sums it up:

State and local borrowing, once thought of as a way to finance essential infrastructure, has mutated into a source of constant abuse. Like homeowners before the housing bubble burst, states and cities have gorged on debt, extended repayment times, and used devious means to avoid limits on borrowing—all in order to finance risky projects and kick fiscal problems down the road. Though the country’s economic troubles have helped expose some of these unwise practices, the downturn has brought not reform but yet more abuse. Even as Tea Party protesters and taxpayer groups revolt against excessive government spending and taxes, they are paying too little attention to the gigantic state and local debt bomb. If it can’t be defused, we’re all at risk.

Where did this come from? Well, municipal government’s have long issued bonds (borrowing money) to pay for public services given the erratic nature of tax collection. And in principal it isn’t a bad thing to do. What is bad is letting that borrowing get out of hand, and basing a bond issuance on unrealistic expectations for revenues to pay it back down the road.

How Bad Is It?

Now, if you ask a muni trader right now, they will tell you the debt bomb fears are overblown. Of course, that’s what all the banks said prior to the subprime bubble. And that’s what they said during the subprime bubble about fears that rising delinquencies would spill trouble over into the rest of the economy. So healthy caution is not unwarranted.

How bad is the problem and why is Whitney so worried? Here are some figures from the City Journal piece:

  • Between 1840 and 1880, total state and local debt outstanding grew from $200 million to $1 billion (or $22 billion in today’s currency).
  • By the 1920s, debt had grown to the equivalent of $250 billion in today’s dollars.
  • In 2000, state and local debt had reached a whopping $1.5 trillion
  • Today, the total muni debt figure has grown to $2.4 trillion

If you want to think about it another way, total muni debt has grown from 12 percent of GDP in 1980 to 22 percent of GDP now. That is a significant debt load being carried by state and local governments, most of whom are not experiencing good times right now. It’s no wonder Whitney, Malanga, and others are worried.

This Has Happened Before

Unfortunately we have a precedent for what cities in financial chaos look like. New York City spun out of control in the 1970s. Mayor John Lindsay boosted city spending on social welfare programs by borrowing to pay for the services, but by 1975, the city of New York was borrowing $500 million a month just to pay its bills, according to Malanga. Eventually creditors lost faith in the city and the government had to bailout Broadway.

In a way, we have already seen a repeat of this through the Stimulus bill passed in February of 2009. That legislation included hundreds of billions in aid to states to help them maintain their budgets and not make cuts. It has put of the inevitable for many municipalities that are coming face to face with reality now that those funds are running out. What Whitney fears is more like Cleveland in the late 1970s. Borrowing from Malanga again:

Three years after New York’s crisis, Cleveland actually did default on $14 million in bonds, in the first major municipal bankruptcy since the Depression. Like New York’s, Cleveland’s budget had swollen rapidly, expanding by 42 percent between 1972 and 1977, even as the city’s population and tax revenues were falling. Cleveland funneled millions of dollars borrowed for capital expenditures into day-to-day operations until the banks refused additional credit and the city’s money ran out. Cleveland spent two years unable to borrow and had to make big spending cuts before returning to solvency.

If this were to happen on a wide scale across the U.S., it would be fiscal chaos—and potentially destabilizing for some of the banks. Citigroup is the most exposed to municipal debt, though they can weather a muni storm since they are still partially owned by Treasury. But that might not be the case for everyone.

Could It Really Happen?

Presumably you’re reading this on a computer with an Internet connection. Open up another browser and google (or bing) “fire department job cuts” and see what you find. I’ll wait…

You can replace fire department with police and find the same thing—a lot of stories about a lot of cities struggling with their budgets. This is a reality going on now. Across the country we are seeing cities struggling to stay alive. Just look at Detroit. The city is having to cut police (not good news for the crime riddled city), city lights, road repairs, and cleaning services. You may be able to get a good house for $12,000, but you’ll have to contract out your garbage service and security. The cuts in city budgets are affecting as much as 20% of the population, according to Elena Moya.

Some will argue this is a crisis of tax deprived budgets left in ruins by Reaganomics thinking public servants. And in some cases, it is true that taxes were cut without a view to how that might affect revenues for public services. But the broad trend for the states has been a dramatic growth in spending, without ensuring the tax revenues were sustainable to support the new programs. From 2002 to 2007, growth in spending out paced revenue by fourfold (accounting for inflation):

In 2002 total combined state revenue was $1.097 trillion (see Figure 1). In 2007 this figure had risen to almost $2 trillion. That’s an 81 percent increase, at a time when prices plus population increased 19 percent. So total revenue increased more than four times faster than inflation and population growth.

That is a pattern seen from the state level down through county and city governments. Furthermore, you don’t have to look much farther than what the debt has gone to pay for to understand that this is not a problem brought on by reduced tax revenues.

California has been a leading culprit in this regard, funding failing projects that range from sports facilities to shopping malls. Development projects aimed at increasing economic growth have only bungled budgets by piling on unending debt. In San Jose, a redevelopment agency started 52 years ago to wipe out blight has claimed it is getting worse, meaning they need more property taxes and muni bond issuance. Cleveland is also a great example of debt funded government development projects that have failed, and my colleagues at have well documented it in a series of engaging videos here.

Beyond the Spending

But it gets worse. If the direct spending mismanagement was a flood that has left governments barely treading water, pension programs are a category-5 hurricane barely off shore. NCPA report that according to a study from the Pew Center on the States:

  • State and local governments now owe at least $1 trillion to public employee pension accounts.
  • To pay that debt, taxpayers would have to spend $1 million a day for the next 2,740 years.
  • That works out to about $8,800 for each American household, on top of their estimated $120,000 share of our national debt.

And the scary part is that the Pew figure of $1 trillion is a conservative estimate that only included major cities and the states.

For example of how egregious the failure has been, look at Washington state: “According to Pew, state lawmakers have failed to make the total required pension contributions since 2001. In fact, between 1999 and 2008, Washington’s pension liabilities outpaced assets almost 2 to 1. And those figures don’t account for state investment losses due to the recession.”

We Should Be Concerned

In short, there is plenty of reason to justify Whitney’s concern. That being said, the White House has made it very clear they do not want states to fail, meaning there could be a big push to make sure state and local governments don’t fail. But the Tea Party and GOP control of the House could make that very challenging. And even with Detroit’s valiant efforts to stave off default as proof that the wave of defaults may be years down the road, the deck is stacked against municipalities right now.