Risk for Municipalities is Overstated?
I read a recent Chicago Fed Letter, titled “Local Governments on the Brink.” It was written by Richard Mattoon, senior economist and economic advisor at the Chicago Fed. The interesting takeaway from the letter is the author’s argument that the local municipality fiscal problem is overstated. Here’s a quick summary.
Local Governments Have Problems:
1. The drop in real estate values (both personal and commercial real estate) is reducing tax revenue (in some municipalities). Property taxes comprise 72% of all local tax revenues (2007 – 2008) and the percentage has been relatively steady, but total revenue has declined.
2. More than property taxes, development fees and real estate transfer taxes (which exploded during the boom) have evaporated. (As an example, Chicago’s transfer fees dropped from $250MM to $70MM.)
3. State governments are reducing payments to municipalities.
4. Underfunded public pensions are consuming larger percentage of smaller state revenues.
5. Muni bond market did poorly at end of 2010 and into 2011 – making it difficult to issue debt.
Arguments Against a Tidal Wave of Bankruptcies
1. Since 1934, there have only been 600 local government bankruptcy filings. From 1970 – 2009, the cumulative default rate for local governments was .09%. By comparison, it was 11.06% for corporate bonds.
2. Local municipalities have greater fiscal resources than commonly discussed. Municipalities have “rainy day funds” (ending balances for general funds) of 21.4% (on average) of general fund expenditures.
3. Local municipalities can take intermediate corrective budget action to avoid bankruptcy. Because of the stigma involved with bankruptcy (and the difficulty of future borrowing), municipalities have a strong incentive to avoid bankruptcy.
4. While local governments have been increasing their debt, the ratio of municipal debt to GDP was 14% in 2009 (approximately the same level as 1985 – 1994).
5. Only 2.5% – 5.5% of municipal debt is expiring each year over a 20-year period. So there is not going to be a period of huge need to refinance. Municipalities tend to issue debt for infrastructure and they tend to match the term of the debt to the life of the project.
6. Even in the event of bankruptcy, recovery rates tend to be high for municipal bankruptcies (although this could be different for retirees).
The Property Tax Drop is Misleading
1. There is a lag in reassessing property values. So, it’s possible that a further drop may occur.
2. But, in some areas, the dollar amount of total taxation is fixed. So, dropping home values doesn’t change your bill (if everyone’s value is dropped proportionally).
If we’re not going to see a lot of bankruptcies, why did the muni bond market get hurt?
1. It might have been the result of a glut of debt that came to market.
2. Continuation of Bush tax cuts may have hurt desire for muni bonds.
Some Final Thoughts
Bankruptcy for municipalities is probably not a huge concern at this point. But, there are certainly municipalities that are in trouble – and obviously, I would worry if I were expecting a pension from an unfunded municipal retirement plan. While the municipal debt levels don’t sound excessive (in aggregate), the pension liabilities (and health care liabilities) do not show up in the debt levels. These are the real problems – just like with the federal government.
If you want an idea of the size of the problem, total state and local debt was about $2.5 trillion in 2007 – 2008 ($1 trillion for state and $1.5 trillion for local). Ten years earlier, this was $1.3 trillion ($500 and $800 billion). One estimate of the pension underfunding is $574 billion. But, depending on the assumptions you make, this underfunding could be $1 – 3 trillion – which would come close to doubling the outstanding municipal debt.
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