Panel: States Going From Bad to Worse

SANTA ANA PUEBLO, N.M. — The short-term fiscal outlook for states is bleak. The long-term outlook is even bleaker.

Members of a panel dubbed “State of the States: Lessons Learned and How to Look Forward” at the National Federation of Municipal Analysts conference here on Wednesday laid out the challenges facing states, both immediate and eventual.

Between a recession-induced squeeze on revenue, continuing demand for services, and trillions of dollars in unfunded pension liabilities, the consensus was

not pretty.

John Cape, senior managing consultant at Public Financial Management Inc. and the former budget director for New York, had an artful way of putting it: “The fiscal situation basically sucks,” he said.

State tax receipts shriveled 11.3% to $687.5 billion in 2009 from $774.9 billion, according to the Census Bureau. Income and sales taxes in particular were devastated by the recession.

Adjusted for inflation, state tax receipts are flat versus 10 years ago, Cape said.

States face a collective budget shortfall of $136.1 billion through fiscal 2012.

“Things aren’t getting better any time soon,” Cape said. “We’re seeing very slow revenue recovery but a fairly robust level of spending growth that is ­driving budget gaps into the out-years.”

Cape expects states’ fiscal situations to remain “relatively bleak” for a couple of more years.

After that, things do not get much better.

Lynn Turner, a trustee of the Colorado Public Employees’ Retirement Association, said states are bound to hit a “brick wall” in the next two decades because of swelling pension obligations.

A Pew Center on the States report found the present value of states’ pension obligations exceeds their assets dedicated to pay those obligations by $1 trillion.

In fact, Turner said, the shortfall is far greater than that.

Pension accounting allows states to reduce their pension expenses by an assumed return on investments. States typically assume a return of around 8% — a rate that recent history suggests is too high.

Because states are assuming a return on investment that they are not actually getting, balance sheets understate their unfunded liabilities, Turner said.

Worse, states are not demanding enough contributions from workers because of the on-paper-only assumption that they are collecting enough on their investments.

In reality, the unfunded liability is more like $2 trillion to $4 trillion, and growing, according to Turner.

“These states are in deep trouble because these are huge, huge numbers,” he said.

To illustrate, Turner showed the balance sheet for the Colorado state fund. The fund reported a $17.9 billion unfunded liability, which represents the difference between $57 billion in present-value liabilities and $39.1 billion in assets devoted to meeting those liabilities.

However, he said the $39.1 billion number is a phantom.

The fund’s assets got clobbered in the financial crisis, and are now actually $29.5 billion.

Because of the rules of pension accounting, the loss will be eased in over time. Thus, an economic deficit of $27.5 billion appears on paper as a $17.9 billion deficit.

The silver lining is that even with such enormous distress, municipal defaults remain rare, Matt Fabian, managing director at Municipal Market Advisors, pointed out.

About $20 billion in a $2.8 trillion universe of municipal debt has reported a default since July 1.

Most of that involved technical defaults that did not interrupt payments to bondholders.

Furthermore, defaults are mostly concentrated among smaller, weaker credits, like dirt bonds in Florida.

Fabian theorized that states may become a smaller portion of the overall municipal market. In 2009, state governments and authorities sold $181.8 billion of the almost $409.9 billion of total municipal debt sold, according to Thomson ­Reuters.

As the federal government seeks to exert more control over state and local infrastructure spending and states seek to pass along their costs to localities by cutting services, the stock of outstanding state general obligation debt will probably shrink, Fabian said.

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