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How States Can Fix Budget Crisis

Letting a state fail means cities and towns could follow

What is needed is the political will to make tough choices

Many states face two significant fiscal challenges. The first is the long term problem of setting enough money aside to pay for employee pensions. The second, and more pressing problem, is closing what is estimated to be a multi-billion dollar budget gap in fiscal 2012.

"Near term budget gaps for states are immense," though not unmanageable, said Matt Fabian, a managing director at Municipal Market Advisors. "The states have the resources to cover their gaps. They could raise taxes, cut spending appropriately and borrow in the near term to cover their spending gap."

States are caught in an extended fiscal squeeze caused by rising costs and lower tax receipts. In addition, the aid distributed by the American Recovery and Reinvestment Act of 2009, is pretty much used up.

Still, states have not sat idly by relying solely on federal aid to plug their short term fiscal holes. BMO Capital’s Justin Hoogendorn said 45 states had cut some spending, while 30 states had raised taxes. But their efforts have not been robust enough to bridge what the Center on Budget and Policy Priorities estimates to be a $125 billion dollar gap between states’ revenue and spending in fiscal 2012.

It’s a gap so large that some politicians, including former Speaker of the House Newt Gingrich, think the best solution is to let states file for bankruptcy. This has happened only once, in 1933 when Arkansas stopped paying its debts in midst of the Great Depression. As a solution, municipal strategist Chris Mier believes bankruptcy would cause more harm than good.

"The problem specifically with Chapter Nine for states is the municipal market does not extract a penalty rate or an insurance rate against states going into bankruptcy because it is not allowed," said Mier, a Managing Director at Chicago's Loop Capital. "Once you allow it, whether a state is likely to do it or not, you're going to get a risk assessment coming into the marketplace and that risk assessment could be significant. It's hard to know how significant but it could be ten, fifteen, twenty basis points. Who knows?"

Along with permanently increasing the borrowing costs for states, letting a state fail means fiscally troubled cities and towns could follow. And while it might work for private companies, the lengthy and expensive bankruptcy process could use up resources cash-strapped states cannot afford right now.

Municipal Bond Maze - See Complete Coverage
Municipal Bond Maze - See Complete Coverage

Furthermore, Fabian points out states can already do what bankruptcy allows private companies to do. "States can renegotiate union contracts," he said. "They can work out restructurings with bondholders."

With all these tools at their fingertips, what is needed more than anything is the political will to make tough choices states will need to make. Additional spending cuts are likely, including layoffs.

In the meantime, muni experts point out states can renegotiate contracts with servicers, raise fees on things like drivers license renewals, sell assets and privatize prisons and tolls roads to cut expenses and raise cash.

They are also likely to start looking for additional sources of revenue. One currently prohibited, but with big potential, is taxing Internet sales.

"Inevitably, this is something that has to come," said Fabian. "An increasing number of sales go over the Internet, and that is an increasing source of revenue for states to tap."

In the near term, muni experts said solving a state’s near term problem is best handled by the tried and true methods of cutting spending and raising taxes or fees. This time though, with such a large budget gap to bridge, the reverberations of these actions will be felt well beyond the states' capitals.

For the many towns, cities and municipalities relying on state aid to fill out their own budgets, the cuts by states will likely make their fiscal problems even worse.


Watch special coverage of the municipal bond crisis, "Muni Maze," all day Monday, February 14 on CNBC.