Twenty-seven of the states that SNW Asset Management follows most closely have now filed audited Comprehensive Annual Financial Reports (CAFRs) for fiscal year 2014. Below is our take on the financial performance of these states during the past fiscal year.
We draw our conclusions based on each state CAFR’s Statement of Net Position and Statement of Activities, footnotes detailing bonded indebtedness, liabilities for pensions and OPEBs, inter-fund transfers, and, when necessary, separate CAFRs published for large pension and OPEB plans. This methodology includes closely-governed component units included in the CAFRs, the operations of which can fairly be treated as part of the operations of the states themselves. This methodology allows us to compare state finances in a consistent manner and adds to our confidence in the accuracy of our findings.
We also apply a number of internally-derived metrics to measure (1) the operational performance of the states and (2) the total of bonded debt and other debt-like liabilities to which the states and, therefore, their tax- and rate-paying public are exposed. The most important of the non-bond liabilities are unfunded pensions and “Other Post Employment Benefits” (OPEBs).
Fiscal performance. As was the case in FY 2013, state operations were generally sound in FY 2014. Twenty-four of the 27 states, including 5 of the states that are especially important to SNW’s clients, operated on a breakeven basis or better. The states of Connecticut, Massachusetts and New Jersey were significant exceptions, as each incurred operating deficits of $1 billion or more, measured on a total funds basis. The 27 states also improved their liquidity; the aggregate of readily available cash and investments increased by 9.7% to more than $455 billion, and the ratio of readily available cash and investments to total expenditures improved to an average of 28. Finally, if we look at the ratio of the accumulated net assets of each state to its total expenditures, most of the states again performed well. In 22 states, including Idaho, Colorado, Oregon and Washington, the ratio was 34% or better, often much better. California and Massachusetts posted weaker numbers, 11.5% and 9.7%, respectively. And, unfortunately, 6 years after the trough of the last recession, Connecticut, Illinois and New Jersey have negative net assets ranging between $10.2 billion in Connecticut and $3.25 billion in Illinois. This is why SNW remains cautious with respect to California and Massachusetts, and attempts to minimize exposure to Connecticut, Illinois and New Jersey. That having been said, our basic conclusion is that most, but certainly not all, of the states that we follow closely reported very solid operating performance in FY 2014.
Debt metrics. Now comes the more somber news. Last year, our comment on FY 2013 was that the states did well operationally, but frittered away an opportunity to use their improved liquidity and generally stronger financial positions to begin to address, and perhaps gain control of, their bonded indebtedness and their unfunded liabilities for pensions and OPEBs. In FY 2014, our take is almost exactly the same, only with a greater degree of concern because unfunded pension liabilities increased by a surprisingly large amount. For our group of 27 states, the problem generally does not lie with bonded debt outstanding, which rose by only 1.7% to $800.2 billion, nor with OPEBs, which rose by 2.2% to $502.9 billion. The problem lies with unfunded pension liabilities, which for reasons we do not yet fully understand (and which we will leave for a subsequent written comment), grew by 14.2% to $754.2 billion. That is a huge increase, which is particularly disappointing given that we are 5-6 years into economic recovery and also riding a huge rally in the equity markets, a staple of pension fund investing. Unfunded pension liabilities are now 94% of bonded debt outstanding for our group of 27 states. In 14 of the 27, including California and Colorado, unfunded pension liabilities exceed bonded debt outstanding.
Since bankruptcy court decisions in Detroit, Michigan and Stockton, California treating pensioners’ claims far more generously than bondholders’ claims, owners of municipal bonds must now confront the possibility that they own obligations that will be systematically subordinated to pensioners’ claims if and when troubled municipalities file for bankruptcy. This possibility has not yet been priced into municipal bonds. At the very least, it is now prudent to add unfunded pension liabilities to outstanding bonded debt when assessing municipal credits.
SNW Asset Management has done exactly this for a number of years now, and when we calculate the numbers for FY 2014 we find ourselves very comfortable with the states that we hold in our client portfolios. Our preferred metric for establishing credit comfort is the ratio of outstanding bonded debt plus unfunded pension liabilities to aggregate personal income (API). API is a readily available statistic that allows us to gauge the ability of the tax- and rate-paying public within each state to make good on debt and debt-like obligations. The average ratio for our 27 states is 14.5%. The ratios for Oregon, Idaho, Washington and Colorado are below the 27-state average at 8.7%, 8.9%, 9.8% and 12.5%, respectively (and a lower ratio is good). Texas and Florida, 2 states in which SNW regularly invests, also score well, with ratios of 6.6% and 6.9%. California and Massachusetts are above the average ratio at 16.3% and 18.7%, respectively. For the record, the ratios for our least favorite credits, Connecticut, New Jersey and Illinois are 23.0%, 24.5% and 25.5%. Now, reasonable people may differ regarding what constitutes a dangerously high reading, but the average is almost certainly materially higher than it was 5 or 10 years ago. It would also be wise to keep in mind that these obligations are in addition to the claims on income imposed by mortgage debt and by the debt of everybody’s favorite relative, Uncle Sam.
These warning signals have been apparent for some time now, and it is deeply disappointing, morale-breaking really, that the states keep ignoring them. And so, SNW’s opinion about FY 2014 comes down to a retake of FY 2013 – a good year operationally, not a good year in terms of managing “longer-term” liabilities. The great danger is that for several of the 27 states the long-term has now become short-term; and for the rest, too, the long-term is shorter than it used to be.
Our conclusion is that for a number of years now the municipal bond market has become increasingly, but perhaps imperceptibly, more risky. By the end of FY 2014, however, the bankruptcy settlement in Detroit and the pension crises at both the state and local levels in Illinois have brought the risks into plain sight. More than ever before, municipal bondholders must insist that the credit analysis underlying their investments be well informed, thorough and carefully thought out. At SNW, we have made it our business to do just that.