Dire Warnings for States: 2011 Will be Painful

Technically, states cannot go bankrupt

If a state defaults on its loans, the federal government can put it into receivership

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.”

Recession-themed newsprint cuttings
Recession-themed newsprint cuttings

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 Whitneyoffered 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.

America's Top States for Business - A CNBC Special Report
America's Top States for Business - A CNBC Special Report

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.

Meredith Whitney
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.”

Four State Strategies: Delaware, Montana, Tennessee, and Maine

Faced with record public layoffs, states across the nation are ramping up their efforts to attract new businesses, in order to create additional private sector jobs.

In Delaware, Democratic Governor Jack Markell has decided that budget cuts alone are not enough, saying that, “We’re not going to cut our way to a prosperous future.”

Getty Images

Delaware is a small state, but a powerful one, with a long history with incorporating out of state—and out of country—companies within its borders. More than 60 percent of all Fortune 500 companies, and 50 percent of all American corporations, are incorporated in Delaware, including JP Morgan Chase , Google and the state’s native son, DuPont .

In April, Taiwanese silicon giant Motech joined the ranks of corporations based in Delaware with its merger with General Electric’s silicon business based there. The deal saved about 70 jobs in the area, and Motech officials have announced plans to hire an additional 75 people by yearend.

In addition, Delaware passed a balanced budget for 2010, and as of May is not operating in a deficit.

“We have a fantastic work force and we’re a very responsive state,” said Markell of securing the Motech incorporation. Delaware’s unemployment rate currently stands at 8.5 percent, more than a full point lower than the national average.

Delaware is growing rapidly, with revenues expected to grow by almost $65 million dollars during the fiscal year 2011. Nearly 30 percent of the state’s total revenue is generated by the Delaware Division of Corporations.

The state stands to receive $76 million from the federal government as part of HR1586, signed into law by President Obama this summer. Governor Markell said that Delaware still needs the federal money despite its growing revenue, since the demand for services has grown as well.

“But obviously we’ve got to wean our way off of that, we’re doing that right now,” he said in relation to dependency on federal funding. “We have to continue to grow our way out of this.”

Tennessee Governor's Dire Warning

Nissan North American headquarters in Franklin, Tennessee
Nissan North American headquarters in Franklin, Tennessee

Dependence on federal funding was never an option for Tennessee governor Phil Bredesen, who viewed any help from the government as a one-time deal from the beginning.

Bredesen recently criticized some of his gubernatorial colleagues for treating federal funding as an extension of their own budget, which he said will come back to haunt them in the coming fiscal year when federal assistance runs out.

“They’ve got some tough choices to make,” he said. “The money is not going to be coming in and states, for the most part, have to balance the budget constitutionally.” He predicted that when federal assistance ceases in January, “there’s going to be some states that will be scrambling.”

Bredesen runs his government like a business, expecting the same level of accounting from state officials as the companies within its borders. Bredesen, a former mayor of Nashville, is the first Tennessee governor in modern times to complete two terms without raising the state sales tax. Instead, he has faced the recession with deep budget cuts and state worker layoffs.

“We’ve legislatively done everything we need to go ahead and make the cuts that are necessary,” said Bredesen.

However, a new shortfall of $170 million already has opened in the current $29 billion budget—even after legislators cut $230 million in last year’s session.

Bredesen and his economic development team have increased their efforts to recruit new businesses to Tennessee in order to expand the job market. In the last seven years, Nissan , Hemlock Semiconductor and Volkswagen have all joined Tennessee, and brought close to 200,000 new jobs with them. As of August 2010, the state’s unemployment rate was 9.6 percent—down from 10.9 percent in August 2009.

Running Montana Like a Ranch

Growth is the key word for Governor Brian Schweitzer of Montana, as well. Montana was ranked 36th in CNBC’s Top States for Business. However, Forbes magazine rates Montana as the fastest climber for business friendliness, going from 42nd to 34th to 13th in just a few years.

Open cast mining for iron ore.
Tim Graham | The Image Bank | Getty Images
Open cast mining for iron ore.

“If you’re in the pipeline business, the transmission business, if you are in the oil and gas business, if you’re in the coal business, have a business that can feed any of those businesses, what you need to do is get a bus ticket a business ticket, or drive to Montana because we’ve got something for you,” said Schweitzer.

Schweitzer relies on his ranching background to ensure that Montana grows within its economic means, a strategy that has helped the state become one of only two (North Dakota is the other) without a budget deficit.

“When times are good the cattle are fat, grass is high, crops are good. Put some grain in the bin,” he said, using ranch-speak for managing the state’s revenue. “Store some hay to get you through the second winter, not just the first one.”

The state of Montana currently has a $371 million surplus in the bank.

Schweitzer is committed personally to promoting Montana as a business state, doing everything he can to help local businesses thrive—even giving out his home phone number for house calls—while working to attract out-of-state companies to Montana.

“If you come out to Montana, you want to start a business, call me. Call me at my home number,” he said. “It’s in the book, and I’ll show you around.” At 7.1 percent, the state has the 11th lowest unemployment rate in the nation.

On the other side of the country in Maine, Governor John Baldacci is likewise trying to attract new businesses to a state that ranks sixth at the best place to live in terms of quality of life on CNBC’s Top States for Business 2010 list—but 39th in its overall business friendliness.

In response to the wide discrepancy between Maine as a desirable place to live versus a sound choice to locate business, Baldacci said that, “We’ve made a lot of progress, but we need to do even more work in connecting the dots.”

His administration’s efforts to streamline business practices include shortening the turn-around time on permits from the state’s powerful Department of Environmental Protection (DEP), to 60 days from 90 days. The DEP and its tight permit requirements have historically been an impetus to businesses looking to relocate to the state, as well as for existing companies to expand.

“We like to be protective, but at the same time we want economic development, we want jobs, and we want the economy to pick up,” said Baldacci.

Maine is currently running a balanced budget with $50-70 million in reserves, which Baldacci accumulated without raising taxes. Instead, he opted for budget cuts and administrative consolidation, and in the process has moved Maine from its position as one of the states with the highest taxes in the country down to 15th or 16th.

“It hasn't been easy,” he said. “I've made a lot of tough decisions. I've irritated an awful lot of people.”

2011 Will Bring the True Test

Tough decisions, unpopular initiatives and creative solutions—the strategies used by state officials to mitigate the effects of the recession—are as diverse as the states themselves. States big and small are facing the same problem: how to run the state business more efficiently, with less money.

Uncle Sam and money
Uncle Sam and money

According to Governor Schweitzer, there’s no such thing as ‘too big to fail’ or ‘too small to succeed’ when it comes to managing the state’s fiscal house.

“85 percent of Montana’s budget, as in every other state, is to educate, to medicate, to incarcerate,” he said.

“Every one of us runs the same business. We might be a little smaller shop than the big shop but we have to buy our goods and services the way they do, we have to sell them the same way they do. So just because you’re a Walmart, doesn’t mean that you’re not the same business as the ma-and-pa store down the road. We’re the ma and pa store that’s more efficient than Walmart.”

Whitney’s report on the states painted a bleaker picture of what could happen to these smaller states should the larger ones go under. In that case, state level-efficiency might not be enough to keep the states in the black, regardless of which state is at fault.

"Imagine you're conservative, fiscally sound Nebraska and you have to bail out California, or you're fiscally conservative Texas and now you have to bail out Michigan," she said. She added that, should this situation arise, the consequences on the dollar and the national recovery would be enormous.

"A lots of these states think Uncle Sam will be there just in case. There's going to be some dislocation. You're going to see some problems." -Tennessee, Governor Phil Bredesen

In response to Whitney’s gloomy predictions, Bredesen said that, “You can’t say ‘states’ and talk about all 50 in the same words.” He said that he is more concerned with the enormity of the cuts made in each state, most of which are taking a toll on services that the states have historically provided, including education and healthcare.

Rather than forecasting state failure en masse, Bredesen said that the states’ problems will remain more individualistic: “There are states that are doing fine and have worked their way through these issues. There are states that could be basket cases in the first quarter of the year.” He said that as long as investors review cases on a state-by-state basis, instead of lumping them all together on the same category, “they’ll find great bargains there.”

For some, it’s not a question of hitting rock bottom, but how to climb out of the fiscal hole once they do.

America's Top States for Business - A CNBC Special Report
America's Top States for Business - A CNBC Special Report

Forty eight states addressed shortfalls in their fiscal year 2010 budgets, totaling $191 billion or 29 percent of state budgets—the largest gaps on record, according to a report by the Center on Budget and Policy Priorities.

Moving forward, the first quarter of the 2011 fiscal year will be a true test of how far the states have come in repairing their bruised economies.

"A lot of these states think Uncle Sam will be there just in case,” said Bredesen, suggesting that those states may learn the hard way that a federal safety net is no longer available.

“That’s the thing that’s going to be difficult to get through,” he added, saying that those states that haven’t made budget cuts—opting instead to fill their budgets with stimulus money —are going to be pressed for cash. “There’s going to be some dislocation,” he predicted. “You’re going to see some problems. “

For those states that have reached the nadir of their financial troubles, the only direction to proceed is up, despite the continued cuts and whatever federal assistance that might entail. “The economy is at least bottomed,” said Bredesen. “We can feel the bottom with our toes and it’s coming back.”

Governor Gregoire and her team of economic advisors remain cautiously realistic, if not optimistic.

“There’s not more bad news,” she said. “It’s just going to take us a while to get out of it.”