Default Position

Why we needn’t worry too much about municipal bankruptcy.

Harrisburg, Pa.

Harrisburg is Pennsylvania’s ninth largest city, a sleepy and rusting industrial hub on the Susquehanna River notable mainly for its status as the state capital. Nevertheless, in 2010 it got an outsized share of attention from investors around the globe who feared—and some still fear—that the city would be the canary in a very big fiscal coal mine: It would be the first in a wave of American cities to default on its debts or declare bankruptcy.

The recession, of course, forms the bleak backdrop. In every downturn, tax revenues decline and spending on social programs—food stamps, unemployment insurance, etc.—increases. Both of those elements push budgets, local or federal, into the red. For Washington, that is not much of a problem: The government just runs deficits. But every state save for Vermont and virtually every town and city, including Harrisburg, is required to keep funds going out equal to funds coming in, recession or no.

So during downturns, local and state governments cut their budgets and find new sources of income to remain afloat. They use up their rainy-day funds, amassed during surplus years. They cut spending on nonessentials, like streetlamps. They hike taxes and fees. They fire employees, slash salaries, reduce pension contributions, trim school budgets, abandon building projects, cut back on firefighting and policing services. Sometimes they even issue bonds just to stay afloat.

For the most part, municipal bonds make safe, low-risk, low-reward investments. They are not quite the equivalent of Treasury debt, which is considered basically risk-free. But historically, their rates of default come in around one-third of 1 percent, far lower than the rates for, say, corporate bonds. Thus, investors around the world own about $2.8 trillion in American municipal debt—an amount that has more than doubled in the last decade and increased about 35 percent over the course of the recession.

In 2010, state and local governments encountered fiscal crises unprecedented since the Great Depression—with budget gaps totaling about $120 billion, according to the Center for Budget and Policy Priorities. Tax revenue plummeted. Stimulus funding from Washington started to dry up. On Wall Street, analysts started wondering whether municipalities would fail to make ends meet and default on their debt.

What happens when a city or town or state defaults? Well, that depends on the debt. Municipalities issue two main classes of bonds. One comes with a “general obligation” pledge, meaning that the government agrees to raise taxes or take other measures to pay bondholders back. But they also issue riskier “non-GO” bonds, or revenue bonds—often to fund the construction of things like hospitals, universities, and housing complexes. It’s those bonds where the defaults happen, for the most part. According to Moody’s Investors Service, between 1970 and 2009, municipalities have defaulted on Moody’s-rated debt only 54 times, and 51 of those defaults came from bonds to finance things like housing projects.

That leads us back to Harrisburg and an unfortunate truth: A government that cannot pay its debts does not pay its debts. The city has teetered on the edge of ruin for about a year, but the problems started long ago. Harrisburg started going on a spending binge—really, a bender—in the 1990s: $125 million for improvements to an incinerator, tens of millions for a Civil War museum, millions more for parking garages and a baseball stadium. It even reportedly issued debt to buy a $125,000 gun once owned by Doc Holliday for a Wild West museum that never materialized. (The city forced the former mayor to sell off the $8 million collection of Western memorabilia he had amassed for a museum that did not exist.)

Now, with revenues falling and spending for social programs climbing, the city of fewer than 50,000 has a debt of more than $300 million. (This year alone, its debt payments equaled 110 percent of its general fund. And total debt on that incinerator has climbed to a whopping $288 million.) Earlier this year, it mentioned bankruptcy as an option, though it seems to have walked back from the cliff, instead settling for renegotiations with bondholders and cuts. And, after the city warned it might skip a GO bond payment in September, Gov. Ed Rendell announced the state would help it out with $3.3 million.

Harrisburg, surely, is a mismanaged outlier. But other municipalities are not much better off. The possibility of bankruptcy has been whispered in Los Angeles. Jefferson County, Ala., and towns near Detroit have shouted it. Vallejo, a city of more than 100,000 east of San Francisco Bay, is currently in Chapter 9. And states like California and Illinois are facing tremendous shortfalls. The whole situation has Wall Street analysts and bond investors worried. What if cities like Harrisburg decide to just throw their hands up?

The most vocal analyst considering that scary outcome is Meredith Whitney, a longtime financial sage who predicted the near-death of Citi. For months, Whitney has been saying that a muni debt crisis might be right around the corner—with state and local budgets strapped and few noticing just how badly the math does not add up. She released an influential report on the matter this fall. And she gave details on her assessment to a broader audience on 60 Minutes last week. The crisis “has tentacles as wide as anything I’ve seen,” Whitney said. “I think next to housing this is the single most important issue in the United States, and certainly the largest threat to the U.S. economy.” She predicted 50 to 100 “sizable” defaults, both GO and non-GO, in the next year.

Other analysts question her predictions. For one, they point out that defaults on non-GO debt—for things like hospitals and housing projects, debt already considered more risky—are happening at a slower rate than in years past. The National League of Cities notes that there have been at least 72 defaults this year, down from 204 in 2009 and 162 in 2008. Considering the thousands of bonds issued in the last decade by the 50 states,19,000 cities, 4,000 counties, 15,000 school districts, and tens of thousands of individual projects—that’s not too bad.

In addition, analysts say, a number of municipalities have demonstrated that they take their debt payments seriously and are willing to sell property, raise taxes, hike fees, plead with the feds and state officials, and otherwise do whatever they have to do to pay their bondholders. In the case of Harrisburg, for instance, though the city flailed in the face of its debt payments—debt payments it knew about for years—the state stepped in. “We couldn’t stand by and let the city default on these bonds,” Gov. Rendell said.

Other analysts hold that the crisis will test how state and local governments will manage their budget gaps, but ultimately most will manage them. “We believe the crises that many state and local administrators find themselves in are policy crises rather than questions of governments’ continued ability to exist and function,” says a report from Standard and Poor s. “They’re more about tough decisions than potential defaults. This is because, for the states in particular, debt service generally holds a priority status relative to other obligations.” In other words, not every debt issuer is as stupid as Harrisburg.

Indeed, the muni market is huge and diverse. Surely, individual hospitals and housing projects will continue to default—and will make up most defaults. Surely, some towns and counties will fail to close their fiscal gaps, and will seek help from states. Surely, some states continue to tread dangerously unsustainable fiscal paths.

And it’s the states that raise the biggest, and most pressing, questions. What will happen if California or Illinois or New Jersey starts to falter? What if unionized workers refuse to accept more cuts, or pensioners revolt? Right now, most expect that the federal government will step in to backstop the states. Warren Buffett, for one, argues the point: “It would be hard in the end for the federal government to turn away a state having extreme financial difficulty when they’ve gone to General Motors and other entities and saved them.”

But California is a whole lot bigger than Harrisburg, and conservatives are already warning against bailing out “beggar states.” Pension liabilities, in particular, loom large. And even if a total muni crisis is not around the corner, fiscal problems, in all their horrible variety, will be with the United States for a long time.

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