State of the States: An Opportunity Foregone

Summary
In fiscal year 2013, our sample states continued to rebound from the recession of 2008-09.  Aggregate revenues exceeded aggregate expenditures by greater amounts than in fiscal years 2012 and 2011, and liquidity also continued to improve.  The states’ capitalization metrics also recovered.  Unfortunately, the states’ fiscal successes did not extend to their debt metrics.  Bonded indebtedness was well-controlled, but unfunded pension liabilities rose faster, even with large gains in the equity markets that are favored by pension managers.  Our bottom line for the states’ debt metrics is that they are accelerating faster than growth in all revenue sources.  The result is debt metrics are structurally out of balance with underlying state revenue outlook.  What is most discouraging to us is that so many of our sample states – virtually all of them, in fact – did not use the generally benign financial environment in FY 2013 to begin the process of controlling and ultimately reversing the relentless growth of their non-bond liabilities.  In all, FY 2013 presented a foregone opportunity to reduce the pace of long-term off-balance sheet liabilities growth and to better align future obligations with a sustainable rate of revenue growth.

Methodology
Each year, as part of our credit process, SNW Asset Management examines a sample of the most investable and relevant 29 states plus the Commonwealth of Puerto Rico.  We do this to assess the states’ fiscal performance and exposure to bonded indebtedness and other liabilities including unfunded pension obligations and “other post-employment benefits” (OPEBs). 
Our sample includes the states in which the vast majority of our clientele reside or where debt is offered at attractive levels.  We conduct this  study because we want to track the financial health of the states in which our clients are directly exposed to credit risk, by owning bonds issued either directly by the states or by local governments therein, which are necessarily affected by economic and financial issues facing the state as a whole.  We gauge the financial health of our sample states by looking primarily at three fiscal measures.

  1. Operating Performance: revenue divided by expenses
  2. Liquidity: unrestricted cash & investments divided by total state expenditures
  3. Capitalization Ratio: total net assets reported on the balance sheet divided by total expenditures

We also examine two metrics estimating exposure to longer-term liabilities.

  1. Percent of Personal Income to Bonded Debt + Pension Liability: bonded debt & unfunded pension liabilities divided by state aggregate personal income
  2. Percent of Personal Income to Bonded Debt + Pension Liability + OPEBs: the same as above but adds unfunded OPEBs divided by state aggregate personal income

Only 13 states exceeded the 104.9% average for the sample, indicating that 17 of the 30 states and territory continue to operate at margins that are positive but a bit thin.  However, in general, at SNW we conclude that in terms of fiscal performance, FY 2013 was a solid and successful year for most of our sample states.

The states’ capitalization metric, which is the cumulative result of long periods of financial operations and is less volatile than liquidity metrics, also improved.  Within our sample, capitalization (total net assets divided by expenditures) averaged 69.9%, ranging between 675% for Alaska with its large Permanent Fund and -40.6% for Illinois.  The negative number for Illinois reflects the state’s large negative net asset balance – the result of years of financial mismanagement.  Connecticut and New Jersey also have negative asset balances, only not as big as the one in Illinois.  The chart below shows the comparative capitalization metrics for the states in our sample.

On a positive note, total revenues exceeded total expenditures in the sample, allowing states to continue to rebuild liquidity.  Liquidity is readily available cash and investments divided by total expenditures and ranged between 600% in Alaska (again, buoyed by the large, oil-driven Permanent Fund) and 7.8% in Connecticut.  The following chart displays the liquidity performance of our sample states.

Findings – Debt Results
Unfortunately, the states’ fiscal successes did not extend to their debt metrics.  Bonded indebtedness was well-controlled, rising by only 3% from the prior year, but unfunded pension liabilities rose by more than 6% despite large gains in the equity markets favored by pension managers, and unfunded OPEBs rose by more than 4%.  The OPEB numbers are actually lower by $20 billion, or roughly 4% of the sample’s OPEB total, because Michigan abandoned pay-as-you-go financing in favor of an actuarial approach coupled with an unrealistic 8% assumed rate of investment return which significantly reduced its reported OPEB obligation balance.  OPEBs, in particular, are likely to grow very rapidly in the years ahead because most states do not fund actuarially-required annual contributions (ARCs) at anything close to 100% – 40% or less is the norm.

Our bottom line for the states’ debt metrics is that they are material, growing at an accelerating pace and pressuring the economic resources in some state.  Outstanding bonded indebtedness and unfunded pension liabilities averaged more than 14.8% of aggregate personal income (the annual personal income of each state’s citizenry) in FY 2013, ranging from 3.9% in Tennessee to a staggering 39.9% in Alaska.  These are “hard” liabilities which state and local courts are unlikely to allow to be reduced in any substantial way – short of federal bankruptcy decree.  Adding in unfunded OPEBs, which are “softer” liabilities but liabilities which the states must nonetheless ultimately make good – the sample average rises to more than 19.5% of aggregate personal income. The chart below displays the total of bonded debt plus unfunded pension and OPEB liabilities versus aggregate personal income for each of the states in our sample.

Outstanding bonded indebtedness plus unfunded pension and OPEB liabilities exceed $100 billion in each of 6 states – Ohio ($112 billion), Texas ($137 billion), New Jersey ($175 billion), New York ($231 billion), and California ($324 billion) – and account for 55% of the sample’s total.  These are big numbers.  Ranked against one another, 18 states do better than sample averages of percent personal income (debt + pension + OPEB), meaning that the states which do worse than the sample average do very much worse.  The states which fare worst when liabilities are measured as a percentage of aggregate personal income are, in descending order, New York, South Carolina, Massachusetts, Ohio, New Jersey, Connecticut, Illinois, Hawaii, and Alaska. 
 
Conclusion
What is most discouraging to us is that so many of our sample states – virtually all of them, in fact – did not use the generally benign financial environment in FY 2013 to begin the process of controlling and ultimately reversing the relentless growth of their non-bond liabilities.  Although in most states, pension and OPEB liabilities are issues for the intermediate- to longer-term and are not yet immediate problems, the negative implications are very real, and if not now, when will they ever begin to be addressed?
In terms of SNW Asset Management’s process of constructing portfolios and managing credit risk for our clients, these are the facts as we see them.  The longer-term financial environment for the states and their political subdivisions is one which we think requires intensive, ongoing care in the appraisal, selection, and monitoring of municipal investments for our clients.  We hope that this summary of our municipal credit work and the lessons which we draw from it will reassure our clients that we continue to be diligent in managing their investment assets, always trying to look a little deeper into the credit characteristics of the securities they own, and making it our business to distinguish accurately between better and lesser credits.