Dire Warnings for States: 2011 Will be Painful

When asked recently if the states are headed toward the same end as some of the country’s major banks, Washington state governor Christine Gregoire had this response:

“We’re not going to fail. That’s not in our vocabulary. I don’t know a governor who would say we’re going to fail.”

And yet, all signs in her state—and many others—point toward a long-term struggle, at best, as they continue to beat back the effects of the recession.

Last month, bank analyst Meredith Whitney offered an ominous prediction for the states: "The similarities between the states and the banks are extreme,” she said, suggesting that some are poised for failure of the same proportions as U.S. banks in 2008.

Whitney went on to say that, like the banks, the states have been “spending dramatically and are leveraged dramatically,” noting that municipal debt has doubled since 2000 and spending has long outgrown revenues.

According to economist Nouriel Roubini, municipal debt is currently 20 percent of GDP. He added that unfunded liabilities of state and local public employee pension funds are as high as $3 trillion—or another 20 percent of GDP.

“The issue is whether the federal government will bail out state and local governments with a federal guarantee of their debt similar to that received by Greece,” he said, “And to be generalized to other Eurozone members in trouble via the new European stabilization fund.”

Jim Rogers, the well-known investor and financial commentator, said state failure is an issue that is more important than China's currency manipulation and the midterm elections— although the vote will effect how states move forward into the next fiscal year.

Rogers has been warning of state financial failure for months. However, there are “other, more important things to be preparing yourself for,” said Rogers, including, “the currency turmoil, more inflation, the popping of the bond bubble."

The economic record for the individual states is less encouraging, and all over the map. State tax revenues were 11.5 percent lower in the 2010 fiscal year than 2008, while the need for state-funded services did not decline, and in many places increased.

The unemployment rate in California, the world’s eighth largest economy, stands at 12.4 percent, higher than the national average of 9.6 percent. Major U.S. cities, including Los Angeles and Seattle, are on the brink of financial ruin and threatening to drag their state economies down with them with crippling debt and job cuts.

Whitney warned that should the larger states fail, they might cause problems for the others by creating a vacuum for federal resources and domestic trade.

Just how well—or poorly—do the state economies stack up? Will they need a bailout? And if the "big guys" (California and Michigan) fail, will they take the smaller states down with them?

Alternative to Bankruptcy

Technically, states cannot go bankrupt. In the event a state defaults on its loans, and can’t find any willing lenders, the federal government can intervene and put the state into receivership. It's similar to bankruptcy, but the receiver has the authority to force creditors to renegotiate terms in a speedy fashion, as opposed to the structured process in declaring bankruptcy.

So the question on everyone’s mind in the current economic climate is not necessarily state bankruptcy, but the possibility of receivership. While no state has ever gone into receivership, more states than ever before are nearing the brink.

In an interview with CNBC in September, Whitney said her firm’s two-year report on the "state of the states" was made even more frustrating by a lack of uniform reporting on state spending and debt.

cnbc.com Meredith Whitney

"We couldn't find anything that gave us a clear story, we couldn't find any information that was transparent,” she said. “So we did it ourselves."

One finding in Whitney’s report was the “real danger” that municipalities could start defaulting on their bonds. The cities and towns themselves guarantee these bonds, and the municipalities receive one-third of their revenue from the states. If states hold back those funds to use toward their own budgets, towns and cities won't have the money to make their interest payments.

Tony Crescenzi, vice-president of bond firm PIMCO, said that the pressure on the municipalities is heightened by local unemployment data, most notably with layoffs in the education sector. “States are pushing down their burdens onto local municipalities,” he said, “So it is important for now to focus in particular on local governments.”

Whitney’s predictions came under criticism for their insistence on similarity with the banks pre-crisis. States and the towns within them share taxation and spending, which is a crucial distinction in how much debt burden a given municipality can carry, critics said following Whitney’s report.

Crescenzi said that it is assumed that, while states can’t file directly for bankruptcy, the federal government would step in to help if the need arose. But, he said, “Investors should not depend on this and should not expect states to be able to close their budget gaps through taxation alone.”

He cited revenue bonds as having more appeal because they are backed by the municipalities’ essential services, like water and sewer, giving investors more confidence that the municipalities will be able to meet their obligations.

Regardless of the veracity of Whitney’s predictions, the overall fiscal report card for the states is dismal. Over the past month, 21 states saw their economies grow, while 22 saw them shrink, according to the Philadelphia Fed’s reading. When the time-frame is extended to the past three months, the number of states that saw their economies shrink jumps to 25.

Nationwide, unemployment is one of the main culprits. Since the downturn began in 2007, state governments have struggled with slashing their budgets while at the same time maintaining jobs for their citizens.

“All the private gains and jobs you can make can be paled in comparison when you look at the kind of layoffs we’re going to have to do at local government, state government,” said Governor Gregoire.

The unemployment rate in Washington has held steady at 8.9 percent for three months now, a source of frustration for workers and state officials alike. Washington picked up an estimated 1,000 private-sector jobs in September, but overall payrolls were down 3,200 due to the loss of an estimated 4,200 government jobs.

Responding to Meredith Whitney’s comparison of the states to the banks on the eve of their failures, Gregoire said, “We’re in crisis mode. We the states are not in pre-crisis at all.”