Broke Town, USA
Vallejo, a city about 25 miles north of San Francisco, offers a sneak preview of what could be the latest version of economic disaster. When the foreclosure wave hit, local tax revenue evaporated. The city managers couldn’t make their budget and eliminated financing for the local museum, the symphony and the senior center. The city begged the public-employee unions for pay cuts — all to no avail. In May 2008, Vallejo filed for bankruptcy. The filing drew little national attention; most people were too busy watching banks fail to worry about cities. But while the banks have largely recovered, Vallejo is still in bankruptcy. The police force has shrunk from 153 officers to 92. Calls for any but the most serious crimes go unanswered. Residents who complain about prostitutes or vandals are told to fill out a form. Three of the city’s firehouses were closed. Last summer, a fire ravaged a house in one of the city’s better neighborhoods; one of the firetrucks came from another town, 15 miles away. Is this America’s future?
Cities across America are facing dire financial distress. Meredith Whitney, a banking analyst turned independent adviser who correctly predicted the banking meltdown, has issued an Armageddon-like prediction of mass municipal defaults. Others — notably Newt Gingrich — have suggested that state governments as well as cities should be allowed to file for bankruptcy. Congress held a hearing to examine the idea.
These forecasts of apocalypse have touched a nerve. Americans, still reeling from the devastating impact of the mortgage debacle, are fearful that the next economic disaster is only a matter of time. To anyone reading the headlines of budget deficits and staggering pension liabilities, it takes little imagination to conclude that the next big one will be government itself. The problems of cities are everywhere. The city council of Harrisburg, the capital of Pennsylvania, has enlisted a big New York law firm to explore bankruptcy as a means of restructuring a crushing debt. Central Falls, R.I., is in receivership. Hamtramck, Mich., a small city within Detroit’s borders, says it could run out of money next month. Hamtramck has only 90 employees, yet it is saddled with the pensions and health care obligations of 252 retirees. Detroit itself is at risk. Large deficits will mean closing about half of the city’s schools and will push high-school class sizes to 60 students.
These and other struggling locales do not begin to approach Whitney’s forecast of hundreds of billions in municipal defaults this year. (It would take defaults by 40 cities with as much debt as Detroit to reach even $100 billion.) Some industry experts accuse Whitney of exaggerating the crisis and of worsening the cities’ problems by frightening away investors. Whitney’s theory is that states, whose finances are also in desperate shape, will cut off local aid to preserve their own budgets; cities that have been subsisting on government transfers would become fiscal orphans and, in a financial sense, unworkable. She has not elaborated on her thesis beyond a few well-chosen television appearances. (She declined to talk to me.) But in the two months following Whitney’s warning, investors unloaded about $25 billion in shares of mutual funds that invest in municipal bonds. The selling spree sent the prices of these munis, typically among the most reliable investments, into a free fall.
If muni bonds were to default (causing investors permanent harm, as distinct from the temporary discomfort of price fluctuations), ordinary Americans would lose big. Munis are bonds issued by state and local governments, as well as agencies like hospitals, with the interest going to bondholders tax-free. Their relative safety, plus the tax break, has made them a favorite among individual investors, who own about two-thirds of the total, either directly or via mutual funds.
But what if the burden of municipal woes falls elsewhere than on bondholders? Yes, cities and states have creditors. They also have citizens who rely on their services and who pay the taxes, and they have public employees who are dependent on stable public-sector jobs and often-ample benefits. Whitney isn’t wrong about a crisis in local government; the crisis is here. The question is, will it be articulated in terms of bond defaults or larger kindergarten classes — or no kindergarten classes at all? The efforts in Wisconsin and elsewhere to squash organized labor suggest that politicians are no longer so willing to protect public employees. Teachers and nurses are likely to suffer well in advance of investors.
The United States has nearly $3 trillion in municipal bonds outstanding. Though some are backed by specific projects like airports and toll roads, most are general-obligation bonds; local taxes are used to pay the interest on those bonds before other expenses. Unlike a corporation, whose revenue can disappear, cities do not go away — or at least, most of them don’t. Detroit is in trouble because of its shrinking population, as are any number of towns in the former steel region of Western Pennsylvania. Many former industrial cities are burdened with governments that are out of proportion to their shrunken tax bases. Local budgets were stretched even before the recession; now, diminished tax receipts have threatened their ability to balance budgets. Bondholders in those municipalities have reason to sweat.
For areas with a stable economy, however, solvency is largely a matter of political will. Historically, far fewer than 1 percent of municipal bonds fail, and most that do tend to be issued for quasi public projects rather than cities. Typical is a monorail that links Las Vegas casinos — and that defaulted for lack of riders. In 2008, a record 166 issues defaulted, but the great majority were Florida land developments; essentially, builders used the tax code to finance sewers and water lines and then walked away when the mortgage bubble burst. The issues were small; defaults in 2008 totaled $8.5 billion. Last year, defaults fell to $2.8 billion.
Chastened by their failure to foresee the mortgage bust, the credit agencies have downgraded munis as the cities’ troubles have accelerated. But the agencies that evaluate muni bonds are paid to worry about bondholders, not about kindergartners or local fire departments; consequently, they are not alarmed. Moody’s says it expects defaults to rise in 2011. But the agencies do not predict a default epidemic. “Munis are not like subprime bonds,” Eric Friedland, a managing director at Fitch Ratings, said.
Government entities do seem less exposed to the sort of chain-reaction panic that undid banks. Lehman Brothers needed financing every day; when confidence disappeared, Lehman disappeared, too. Cities are generally not dependent on short-term financing. (A sizable exception involves some $80 billion in variable credit lines expiring over the next six months — which could force some governments to scramble.)
Another factor that tilts against default is that states and cities carry much less debt relative to the size of their economies than do troubled national governments like those of Greece or Spain (or the United States, for that matter). And muni debts generally come due in a steady stream — not all at once. Robert Kurtter, a managing director at Moody’s, says, “State and local governments really don’t have a crushing debt problem.”
Which is not to say they don’t have a problem. For most of the past decade, local government was a growth business. Avid consumption and the real estate boom spurred an abundance of sales- and property-tax receipts; with dollars flowing in, governments got used to spending more and borrowing more. Then, in the recession, tax revenues dried up, while demands for services kept rising. For the last few years, both cities and states have faced severe, recurring budget gaps.
As part of the 2009 stimulus package, Washington gave the states $150 billion. The states became dependent on a higher level of federal aid — 35 percent of their budgets, compared with about 25 percent before. But the stimulus is ending, and the states will have to cut.
"It’s better to cut a deal than go through the pain we have in Vallejo."
Determining who will suffer from budget cuts is a political and a legal calculation. The cities’ problem is that annual spending is greater than revenue; that imbalance does not entitle them to walk away from bond payments. Moreover, states and cities devote less than 10 percent of their revenue to annual debt service. In other words, they have ways of balancing budgets without defaulting. Lately, governments have been taking a chain saw to ordinary spending. The cuts sometimes reflect a retreat from what was once conceived as the essential mission of government. Education is being hit hard. Arizona is seeking a federal waiver to remove 280,000 adults from Medicaid rolls. Massachusetts is stripping out funds for homeless shelters. New Jersey has canceled a commuter-rail tunnel under the Hudson River. If the government doesn’t build a rail tunnel, who will?
States are also cutting aid to cities — much as Whitney forecast — aggravating the loss of local tax revenues. Camden, N.J., which has one of the highest crime rates in the country, has dismissed nearly half its police force. Michigan cities have seen aid diminish by $4 billion. In San Diego, where the city has cut other spending to pay for spiraling pension costs, residents have formed 56 “maintenance assessment districts” to take care of parks and patch up sidewalks. When the city failed to pass a hospitality tax, local hotels banded together and agreed to charge a 2 percent visitors’ fee. Scott Lewis, who writes about politics for the Web site Voice of San Diego, says, “I think the city is dissolving.”
In Wisconsin, Scott Walker, the new governor, declared that the state was “broke.” He does not mean that Madison intends to default on its obligations to debt holders; he means that public employees will have to increase contributions toward their benefits in an amount equal to 7 percent of their pay. For some employees, the cuts will mean real hardship. Public institutions like schools are also likely to suffer. Though elected officials prefer not to mention it, taxpayers will also have to ante up. Illinois sharply raised its income tax; Arizona voted for a sales-tax increase. Both of those states had markedly low tax rates to begin with, but Illinois’s case should be troubling to bondholders. Even after raising taxes, the state is planning to borrow about $12 billion to cover pensions and past-due bills — pushing both benefit costs and current expenses into the future.
The deficit problems have, at times, seemed to blend with the issue of pensions into a single, giant mess. As E. J. McMahon of the Manhattan Institute observes, “This is a conflating of different things.” States and cities have to put money aside to pay for future pensions, and the portion of that obligation that is “unfunded” represents a huge liability — from $1 trillion to $3.5 trillion, depending on your assumptions about future pension-fund investment returns. This underfunding won’t be felt in a big bang but as a continuous burden for years to come.