At the end of 2010, there were many municipalities, some of them quite large, that looked as though they could be heading for financial trouble if they failed to get their operating deficits, as well as their off-balance sheet liabilities, under control. Much to the delight of municipal bond investors, the majority of municipal borrowers took steps in 2011 to raise revenues and reduce spending in an attempt to close the bulk of these budget gaps. While these are accomplishments generally worthy of investor praise, one must dig a little deeper to fully understand how the budget gaps were closed. Investors must ensure that the reduction in budget shortfalls are permanent and not the result of accounting gimmicks, increased borrowing, or other questionable schemes. Today, we would argue that many state and local governments have taken steps to reduce or eliminate their operating deficits, but, in doing so, have increased their debt loads and ignored the underfunding of pensions and other off-balance sheet liabilities.
Over the last year, we have seen a number of high-profile municipalities run into financial trouble, with a few taking the extreme measure of declaring Chapter 9 bankruptcy. Jefferson County, Alabama, and Harrisburg, Pennsylvania, both started down their paths toward bankruptcy years ago, when they took on large amounts of debt to fund civic projects without having the necessary cash flows to pay for them. Central Falls, Rhode Island, Stockton, California, and Detroit, Michigan, have recently become insolvent or nearly insolvent due to weak local economies and high, inflexible cost structures. These inflexible cost structures were mainly the result of growing pension and healthcare obligations that the municipalities were powerless in cutting. Through our credit research, we have discovered numerous municipal borrowers facing the same challenges. Pension and benefit costs are taking a larger and larger share of municipal budgets, causing local governments to face the difficult choice of either raising revenues substantially or cutting basic services in an already weak economy.
A growing number of municipalities are attempting to reduce their pension and OPEB obligations by passing laws or going to court to reduce the costs. Rhode Island, for example, has taken bold steps to rein in its growing pension costs by raising retirement ages and changing the structure of its plan to a mix of a defined benefit and defined contribution. The state treasurer also reduced the growth rate assumption, which causes the pension obligation to grow initially, but makes it easier to reduce a pension deficit once a plan becomes underfunded. Stockton, California, is the first city in that state to become insolvent since the state passed a law that requires municipalities to enter mediation for 30 days prior to any Chapter 9 bankruptcy filing. One of the costs that the city will attempt to cut is its pension costs. The California Public Employees’ Retirement System (“CALPERS”), which manages the pensions of Stockton’s employees, has publicly vowed to fight any attempt to cut the benefits that the city owes. If Stockton does ultimately file for Chapter 9 bankruptcy, it will pit Federal bankruptcy law against a California state law that does not allow for cuts in pensions. This could result in a way for municipalities with perilous financial situations to reduce their cost structures, but would require a bankruptcy filing, thus putting all creditors, including bond holders, at risk. In Wisconsin, voters will be deciding whether to recall their governor, who passed a law that no longer allowed public employees to use collective bargaining agreements. This change, while highly politicized, did have the effect of allowing local school districts to renegotiate high cost services, which would have been difficult to negotiate previously. Finally, in Texas, a state that has some of the strongest credit metrics among the 50 states, we have seen the amount of debt nearly double over the past several years as the state elected to borrow more money rather than cut its expenses to balance its budget. While Texas still has a very strong credit profile and had room to take on the additional debt, we will be watching closely to see if it substantively addresses its deficits or if it merely continues to increase its debt load.
All in all, municipalities are in better shape than they were a year ago, but many are still struggling with high expenses that are difficult or unpopular to cut. We will be analyzing how borrowers manage themselves in an economy where their revenues may not be keeping pace with their growing expenditures. If we feel that a municipality is not taking the necessary action to protect our interests as bondholders, we will not hesitate to sell its bonds. After all, there are plenty of other municipalities that manage themselves prudently and whose debt offers attractive yields.