Will States Face the Deficit Music? Not if Newt Has a Say

Will States Face the Deficit Music? Not if Newt Has a Say

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Dear Newt. Bug off.

That’s the message the National Governors Association and the National Conference of State Legislatures sent to Capitol Hill on Friday in a harshly-worded response to a proposal by conservative legislators and former House Speaker Newt Gingrich to change the nation’s bankruptcy laws to allow states to go belly up.

“Mere discussion of legislation, let alone the existence of a law allowing states to declare bankruptcy would only serve to increase interest rates and create more volatility in bond markets,” the letter, which was sent to the majority and minority leaders in both houses, said.

The governors, most of whom are now Republican, pointed out that states have managed large and growing deficits for three straight years by cutting budgets and raising taxes. Those are their only choices since nearly every state is constitutionally bound to balance its budget.

For instance, the state whose budget is considered the worst off in the nation – President Obama’s home state of Illinois – recently raised its income tax from 3 to 5 percent. And more is coming. The Tax Foundation in a recent report predicted 2011 would be a year of “dramatic tax increases” in the states as federal stimulus money runs out. Other analysts fear state actions to deal with their budget woes could undermine the stimulus generated by the recently enacted federal tax cut.

“Governors and legislators have had to make tough and politically unfavorable decisions to be fiscally responsible and balance our budgets,” the letter said. “Throughout this process, our colleagues never contemplated walking away from our obligations to our constituents or to the bond markets by requesting that the federal government allow states to receive bankruptcy protection.”

The Great Recession hammered state finances, which are largely dependent on income and sales tax collections. A Center for Budget Policy and Priorities report released last month showed 44 states with a collective $125 billion shortfall this year.

In December, stock analyst Meredith Whitney, who made her name predicting the collapse of bank stocks in 2007, shook municipal bond markets by predicting anywhere from 50 to 100 municipalities would enter default this year. A massive muni bond sell-off, which had actually begun in early November, escalated as individual investors, who mostly buy munis through mutual funds, pulled $23.6 billion out of market over the last 12 weeks, according to Lipper unit of Thomson Reuters.

There was even an uptick in action in the small but growing municipal credit default swap market, where hedge funds and wealthy speculators can bet individual securities or bonds are heading for a fall. A number of big banks that deal in derivatives, including Bank of America, Goldman Sachs, JP Morgan Chase and Morgan Stanley, reentered the market last fall after a two year hiatus.

The move angered big state issuers like California. Its state treasurer, fearing the burgeoning swap market would drive the interest rates even higher, demanded that any bank that underwrote bonds in the state publicly disclose whether it simultaneously traded credit default swaps on those bonds, either for customers or its own accounts, according to a report in the Wall Street Journal.

The price of many state and municipal bonds, which move in the opposite direction of interest rates, plunged by nearly 20 percent over the past three months. Long-term rates on tax-exempt, triple A-rated state and municipal bonds, which had sunk as low as 3.7 percent last October, peaked at over 5 percent in January before falling back to about 4.8 percent this week.

However there are signs the rout is nearly over. The exodus of cash from muni mutual funds fell to $1.1 billion last week, down from the $4 billion peak of early January. With rates hovering around 5 percent, Hugh McGuirk, vice president in charge of municipal investments for T. Rowe Price, said he’s now seeing “cross-over buyers stepping in and deciding to invest in munis instead of taxables.”

Smart investors recognize states do not face a short-term liquidity crunch, he said, since state debt payments amount to only 3 to 5 percent of revenues. The states problems, like the federal government, stem from their long-term obligations to retirees.

Many state pension funds have huge unfunded liabilities due to the decline in equities markets, which are still well below their 2007 peaks. Many legislatures also skimped on their pension fund contributions during the fat years to hold taxes down, even as they made generous promises to public employees.
“States don’t have a short-term debt problem,” McGuirk said. “It’s their long-term commitments to pensions and health care costs that must be dealt with.”

Just like the Feds.

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spent 25 years as a foreign correspondent, economics writer and investigative business reporter for the Chicago Tribune and other publications. He is the author of the 2004 book, The $800 Million Pill: The Truth Behind the Cost of New Drugs.