State & Local Finance

Report: Defaults Overhyped

WASHINGTON — Claims that states and localities are facing massive budget gaps, unfunded pension liabilities, and health care costs that will lead to bond defaults and bankruptcy filings are greatly exaggerated, and mask the need for states to overhaul out-of-date tax systems and make other structural changes, a new report warns.

The report, to be released Thursday by the Center on Budget and Policy Priorities, also cautions federal lawmakers against considering legislation that would allow states to file for bankruptcy, warning “the necessity for it has not been proven” and that it “could do considerable damage” by pushing up borrowing costs and undermining states’ efforts to invest in infrastructure.

The policy group plans to hold a conference call Thursday at 1:00 p.m. Eastern Standard Time to discuss the report, “Reality Check: The Truth About State Budgets, Bond Debt, Pension Obligations, and Retiree Health Costs.”

“A spate of recent articles regarding the fiscal situation of states and localities have lumped together their current fiscal problems, stemming largely from the recession, with longer-term issues relating to debt, pension obligations, and retiree health costs, to create the mistaken impression that drastic and immediate measures are needed to avoid an imminent fiscal meltdown,” the center said in the report. “Such mistakes can lead to inappropriate policy prescriptions.”

The report rejects claims that state and local governments have too much debt, used in part to finance operating costs, and that there is a high risk that a significant number of them will default on their bonds.

Governments have issued bonds almost exclusively to fund infrastructure projects, not to finance operating costs, it said. The popular Build America Bond program encouraged borrowing for infrastructure because BABs could only be used to finance capital projects.

Claims that BABs have led to an explosion of outstanding debt “are incorrect” because outstanding debt in the second quarter of 2010 was about 16.7% of gross domestic product, similar to the levels that existed from the mid-1980s to the mid-1990s.

In addition, interest payments on state and local bonds generally absorb just 4% to 5% of current expenditures, as was the case in the late 1970s, according to the center.

Municipal bond defaults have been extremely rare, with the three major rating agencies calculating the default rate at less than one-third of 1%, the center said. Between 1970 and 2009, only four defaults were from cities or counties and most others were on non-general obligation bonds that financed the construction of housing or hospitals.

They stemmed from problems with individual projects and “provide no indication of the fiscal health of local governments,” the report stated.

“While some have compared the state and local bond market to the mortgage market before the bubble burst, the circumstances are very different,” the center said. “There is no bubble in state and local bonds, nor are there exotic securities that hide the underlying value of the asset against which the bonds are being issued.”

“Various pundits have suggested enacting federal legislation that would allow states to declare bankruptcy, potentially enabling them to default on their bonds, pay their vendors less than they are owed, and abrogate or modify union contracts,” the report warned.

This kind of legislation “would be unwise” because, while states have adequate tools and means to meet their obligations, the potential for bankruptcy “would just increase the political difficulty of using these … tools to balance their budgets, delaying the enactment of appropriate solutions,” the center said.

The warning comes as Sen. John Cornyn, R-Tex., is considering drafting bankruptcy legislation for states. Cornyn, a member of the Senate Budget Committee, asked Federal Reserve Board chairman Ben Bernanke about such legislation at a committee hearing last week. Bernanke said states already have the tools they need to avoid fiscal crises.

Claims that states and localities have $3 trillion of unfunded pension liabilities and that pension obligations are unmanageable and may lead to bankruptcy filings “overstate the fiscal problems, fail to acknowledge that severe problems are concentrated in a small number of states, and often promote extreme actions rather than more appropriate solutions.”

Shortfalls in funding governmental pensions have gradually emerged over the last decade, primarily from the two must recent recessions, which have reduced the value of assets in the funds, according to the report.

“States and localities devote an average of 3.8% of their operating budgets to pension funding,” it said. “In most states, a modest increase in funding and-or sensible changes to pension eligibility and benefits should be sufficient to remedy underfunding.”

However, in some states that have grossly underfunded their pensions in past years or granted retroactive benefits without funding them — Illinois, New Jersey, Pennsylvania, Colorado, Kentucky, Kansas, and California, for example — “additional measures are very likely to be necessary,” the report warned.

Nevertheless state and local governments have managed to build up their pension trust funds in the past without outside intervention.

“There is reason to assume that they can and will do so again, once revenues and markets fully recover,” the center said.

Governments have the next 30 years in which to remedy pension shortfalls, according to the report.

Some observers warn that governments in dire crisis have added to unfunded pension liabilities about $500 billion in unfunded promises to provide state and local retirees with continued health care coverage. But “it is inappropriate to simply add the two together,” the center said.

Pension promises are legally binding, but retiree health benefits are not and typically can be changed, according to the report. In addition, states’ retiree health benefit plans differ widely.

“Given the different origins, scope, and potential solutions to problems in each of these areas, calls for a 'global’ solution — such as recent proposals to allow states to declare bankruptcy or to limit their ability to issue tax-exempt bonds unless they estimate pension liabilities using a riskless discount rate — make little sense in the real world of state and local finances,” the center said in the report. “Indeed, some proposed solutions could worsen states’ long-term fiscal picture.”

The confusion between short-term cyclical budget deficits and longer-term issues like debt, pensions, and health insurance, draw attention away from the fact that states suffer from “structural deficits” — the failure of revenues to grow as quickly as the cost of services during healthy economic times, the center said.

Structural deficits stem primarily from out-of-date tax systems, coupled with costs that rise faster than the economy in some areas such as health care.

“It is far more constructive to focus on fixing these basics of state and local finance than to proclaim a crisis based on exaggerations of imminent threats,” the report said.

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