SNW Asset Management has recently completed a review of the financial performance and debt burden of each of the 50 states plus the District of Columbia. The study uncovered a number of valuable credit insights which we will work into our investment strategy going forward, and it also affords us an opportunity to share some of our findings with you, our clients.
Scope and Methodology
We looked both at measures of fiscal performance – revenues vs. expenditures, aggregate net assets as measures of accumulated wealth and financial staying power, and ready cash and investments as a measure of liquidity – and overall debt burden, which we defined as outstanding bonded indebtedness plus unfunded pension liabilities plus unfunded “other post-employment benefits” or “OPEBs.” We measured fiscal performance by using the “Statement of Net Assets” and “Statement of Activities” in each state’s comprehensive annual financial report. These exhibits measure performance on a very broad basis, including the assets and operations of proprietary funds and component units. This would be much like evaluating federal governmental performance by including the activities of federal agencies along with the direct government. While there are other ways to evaluate fiscal performance, our method does have the advantage of erasing the effects of states’ accounting for the same basic types of operations in different fund groups; we therefore have a broad but common method of comparing states’ performance.
Similarly, we opted for a broad but common approach to measuring indebtedness. We included in our measurement of bonded debt proprietary activity and component units’ revenue bonds in addition to general obligations, and we included teachers’ retirement pension obligations as well as overall public employee system obligations in all states (some states combine the two, some do not) to try to measure the net total pension liabilities which represent a potential economic charge on the people of each state. Again, not everyone would do it in exactly this way, but we believe we have established a common, consistent basis for estimating and comparing among the states. All this having been said to provide proper background, here is a summary of our findings:
State of the States - Fiscal Performance
- As we have long suspected, fiscal year 2009 was the cyclical bottom for the states, but, while operations improved in FY 2010, the states have much to do to restore their pre-recession financial standing. In FY 2009, only 5 states ran surpluses according to our method of evaluation; in the following year, 27 states plus the District of Columbia did. However, in the aggregate, the states are still bleeding money. We estimate aggregate state revenues of $1.918 trillion in FY 2010, which was only 96.4% of aggregate expenditures of $1.989 trillion. Still, this represented an improvement over FY 2009’s revenue/expense ratio of 92.5%. The improvement reflects the states’ ability to raise revenues rather than their ability or willingness to cut spending – on average for the country as a whole, state expenditures rose 7.5% between FY 2009 and FY 2010.
- Despite depleting reserves and other assets during the recession, the states still have aggregate net assets of $1.166 trillion as of the end of FY 2010. This represents an impressive amount of potential staying power, but on a state-by-state basis there are substantial differences. For example, Alaska’s oil-royalty-funded permanent fund is part of net state assets which were 580% of FY 2010 expenditures; on the other hand, 3 states – Connecticut, Illinois, and New Jersey – reported negative net assets in their latest reporting period.
- Many states appear to have seen the bad times coming and marshaled an impressive amount of liquidity in the form of cash and readily available investments. Such assets amounted to $522 billion at the end of FY 2010, or an impressive 26% of aggregate expenditures. Here again, there were substantial differences among the states; for 16 of them, this yardstick was less than 15%.
State of the States - Debt Profiles
- On the debt side, bonded indebtedness is large and growing rapidly. In the aggregate, state bonded debt totaled $809 billion at the end of FY 2010; this represents $2,618 per capita, and 6.6% of aggregate national personal income of $12.2 trillion. Unfunded pension liabilities were $656 billion, 76% of bonded debt outstanding, $2,125 per capita, and another 5.4% of personal income. If one assumes that public sector pensions represent legally-protected vested assets of their intended recipients – and hence, like bonded debt, a “hard” obligation of the states to repay – the total burden of such obligations moves to $4,743 per capita and 12.0% of aggregate personal income. (By the way, we have settled on debt as a percentage of personal income as our preferred yardstick because it appeals to us as the best single measure of ability to service the burden of the net debt obligations which we are estimating.)
- As we have pointed out in previous commentaries, unfunded pension liabilities are subject to substantial volatility depending upon the dates of evaluation, the assumed rates of return, and whether estimates are “spot” observations or smoothed over a multi-year period. All of these factors are subject to considerable variation among the states. With that cautionary note, we estimate the national average funding ratio at 77.5% in FY 2010. As is usual, there is considerable variation among the states. The District of Columbia and 7 states – Delaware, New York, North Carolina, South Dakota, Tennessee, Washington, and Wisconsin – have funding ratios above 90%, but 9 states – Connecticut, Illinois, Indiana, Kentucky, Louisiana, New Hampshire, Oklahoma, Rhode Island, and West Virginia – have funding ratios less than 60%.
- OPEBs represent another substantial potential liability for the states. Due primarily to an abysmal national average funding ratio of 4.9%, unfunded OPEBs amount in the aggregate to $587 billion, or $1,900 per capita and 4.8% of aggregate personal income. Although many investors think of OPEBs as a “soft” liability which can ultimately be shed by public entities, there is enough uncertainty about this that we think it worthwhile to add OPEBs to our estimate of the potential burden on the public of all these potential liabilities. The resulting numbers are large — $2.052 trillion, net burden per capita of $6,643, and 16.0% of aggregate personal income.
- It is also worth noting that of these three forms of outstanding potential liabilities, only bonded indebtedness represents a direct investment in productive capital facilities (for example, schools and universities, and transportation facilities) which have the potential to add future value to economic activity in the states and to enhance the ability of the public to repay the debt incurred. By contrast, pension and OPEB liabilities can be viewed as a form of continuing or deferred compensation to public sector employees. Since payment of the workforce is normally considered an operating expense, this is tantamount to bonding a non-capital expenditure. This is not an argument that these liabilities should not be honored; rather, our point is that if one takes the traditional view that it is bad practice to bond operating expenses, then the accumulation of large unfunded pension and OPEB liabilities is bad news, indeed.
There is actually plenty of good news amid all these numbers and ratios. First, in a general way state finances have definitely bottomed out, and we have objective data for identifying and tracking the states which are doing best. In an environment of mixed results, we have plenty of evidence to support our opinions as to which are the better credits. Second, although the numbers are large, they are liabilities which tend to be longer-term in nature. The states do have time to control the incurrence of bonded debt and to improve the funding of their pension and OPEB liabilities. And, if it’s any comfort, the numbers – large as they are, are nothing like the numbers being put up by the federal government.
At SNW Asset Management, we will be putting to good use the state-by-state and aggregate data which are summarized here. More than ever, we know the states in which we are comfortable with credit exposure versus those which we wish to avoid. We also now have a base from which to measure future progress. We plan to keep monitoring and updating the information we’ve compiled so that we can continue to offer our clients close and well-informed attention to the credit quality of their portfolios. Strict attention to credit, as well as a disciplined maturity structure, continues to lie at the core of SNW Asset Management’s investment approach to the fixed-income portfolios which our clients entrust to us.