Experts Talk Budget Challenges, Headline Risk for States, Cities

A former governor, a municipal finance analyst, and a state treasurer Tuesday weighed in on the budget challenges and headline risk that states and cities currently face.

Predictions of defaults and reports of cash-strapped municipalities and states have taken a toll on investor confidence in tax-exempt debt. Bond issuance has been light this year as investors have withdrawn from muni mutual funds.

John Hallacy, head of municipal research at Bank of America Merrill Lynch, said what the tax-exempt market needs is a return of confidence.

“The biggest challenge we have this year is we haven’t been tested on supply and we have to get more buyers back,” Hallacy said during Bloomberg LP’s State and Municipal Finance Briefing in Manhattan. “There are a lot of people out there who have been very sensitized to everything going on.”

While this week’s heavier calendar could indicate that buyers are ready to absorb larger amounts of municipal debt, many states and cities are in the midsts of budget cycles as lawmakers discuss how to balance annual spending plans. Hallacy noted that investors will still take into consideration the sharp spending reductions and-or tax increases that states and localities will need to make to close budget deficits that can run in the billions.

Some issuers have already paid the price of headline risk after financial analyst Meredith Whitney said during a “60 Minutes” episode in December that she anticipates municipal bond defaults this year to be in the hundreds of billions of dollars. Washington Treasurer James McIntire said Whitney’s dire outlook for the muni market pushed up borrowing costs for the state when it headed to market two months ago.

Washington sold $361.9 million of tax-exempt general obligation bonds in January. The Series 2011B bonds priced with yields ranging from 0.42% on a 4% coupon for debt maturing in 2012 to 5.21% with a 5% coupon for debt maturing in 2031, according to the official statement. A 2033 term bond yielded 5.25% with a 5% coupon while a 2036 term bond priced at 5.32% with a 5.25% coupon.

“We did some [bonds] in January and Meredith Whitney cost us quite a bit of money,” McIntire said during the panel discussion. “We’re not very happy about that.”

Talk of states and cities declaring bankruptcy is also in the air. Edward Rendell, who was Pennsylvania’s governor from 2003 through 2011, is not a fan of Chapter 9 municipal bankruptcy for states and localities because such actions would block issuers from accessing the capital markets for short-term budget needs and long-term infrastructure projects. He called municipal bankruptcies a “terrible idea.”

“If you declare bankruptcy, who’s going to lend you money? Who’s going to buy your bonds? Nobody. You will cease to be able to function. It’s an absolutely ludicrous idea,” Rendell said.

Hallacy said that it’s difficult to predict how many municipal defaults could occur this year compared to the $4 billion of debt that issuers defaulted on in 2010. He does not believe that any state this year will default on its bonds or declare bankruptcy. By law, states are unable to file Chapter 9. “The municipal market traditionally finds a way to refund or restructure its way out of the problem before you crash and burn,” he said.

Still, this will be a tough year for states as they compare their spending needs to incoming revenue. With the expiration of federal stimulus dollars and rising retirement and health-care costs, states will have to cut spending on top of expenditure reductions already made in 2009 and 2010. Both McIntire and Rendell said collective bargaining rights should remain available for government workers.

“Collective bargaining has been a very effective tool, I think, in terms of having those negotiations and communications and getting everyone on board early on before we sit down to write out a budget,” McIntire said.

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