The specter of possible widespread municipal defaults has been generating column miles and television hours lately as journalists and pundits argue over the likelihood of a meltdown in the bond markets.
While everyone agrees that ballooning healthcare costs, massively underfunded pensions and contracting revenues weigh heavily on the financial future of US states, some industry analysts have pegged the likelihood of a state default at near zero, while others, such as Meredith Whitney of Meredith Whitney Advisory Group, have predicted doom. Whitney garnered massive media coverage – not to mention criticism – recently for her claim that defaults could be in the region of hundreds of billions.
This has helped to stoke investor fear, but concerns are being fed by more than just the dire projections of prognosticators. With political groups actively calling for legislation that would allow states to declare bankruptcy set against the backdrop of the European Union’s debt crisis, the once impossible thought of a state collapse suddenly seems more possible to many.
Bill Montrone, director of the U.S. Public Sector Finance group at Standard & Poor’s Credit Market Services, vigorously defended his firm’s ratings practice last spring after a group of over a dozen major municipal issuers publicly issued a letter claiming that Standard & Poor’s issued unfairly low ratings to their bonds. Montrone asserted that the tougher standards deployed relative to competitors were necessary - and in so doing emphasized that default risk was real in municipal markets, even if actual defaults are rare. Ironically, Montrone now finds himself in the position of assuaging investors’ fears as he downplays the hype over potential state level defaults that have grabbed headlines, with Standard & Poor’s now holding a more positive view on the muni market and on the possibilities for state bankruptcy.
Montrone spent over a decade as a public finance investment banker at Dillon, Read & Co. before joining Standard & Poor’s in 1994. Known for speaking bluntly about risks in the market, Montrone spoke to Institutional Investor contributing writer Andrew Barber about state default, state policy, and the municipal markets.
Institutional Investor: The question on everyone’s mind is: How serious is the state debt crisis that we are facing?
Bill Montrone: Essentially what we are saying is that we don’t believe the states have a debt crisis. There are some pundits out there who say states are overburdened with debt – if you take a look at the level of indebtedness of the state sector by servicing cost it’s been very constant for the past 40 years with debt services equal to about 4% of annual revenues on average. From that perspective the states are very lightly indebted when compared to other states globally. Ontario Canada’s debt service to revenues is nearly 34% for instance, Bavaria in Germany is close to 10 percent and Lucerne, Switzerland, is 8% compared to New York at 3.4 percent, Illinois at 3.7 percent or California at 4.4 percent. What we really see is a crisis of policy, or perhaps more precisely a crisis of benefits. Generally over 80 percent of US states’ revenues go to health, education and welfare – even when you add in pensions and other post-employment benefits into debt service calculations the numbers still average in the single digits as a percentage of total revenues.
II: So policy will lead, leaving elected officials to make the big decisions. How confident are you they will find the political will to make hard choices?
BM: If you look at individual states you see different responses. Andrew Cuomo is introducing some serious cuts to the budget in NY State, but he is not discussing raising taxes. Jerry Brown has said that he will cut the budget of California to bring the deficit into structural balance unless the voters give him permission to increase taxes. So here are two examples of elected officials who are taking a pragmatic approach to the bottom line. In Illinois the decision was made to significantly raise taxes – proactively taking measures to close the budget gap. So we are watchful at this point. We do have seven states that we currently have a negative outlook on – Arizona, California, Florida, Illinois, Maine, Ohio and Rhode Island. We are watching those states closely but that is not an historically high number, particularly during in a weak economic environment. We remain watchful because most states have a fiscal year that ends in June and what we are seeing now is executives introducing the fiscal 2012 budget that will go through the legislative process over the next several months and provide us with a view of how pragmatic they are willing to be. Generally speaking these discussions of budget cuts are ugly and the process will be a lot like sausage being made but history has shown that the states will likely take the steps that must be taken.
I guess my point is that even if they abrogated their obligations to pay debt service it’s not going to fix anything for them, it’s too small a line item and they will still be left with a huge hole. They know this.
II: So how does this play out for troubled states as they enter the bond market?
BM: As I said we have seven states that currently have a negative outlook and, in the past, states facing these types of issues have seen a challenging debt market environment for a period of years. So these states are not out of the woods yet by any means, but do have a lot of flexibility when addressing these shortfalls. We are anticipating that they will take responsible actions in this situation just as they have in prior recessions.
II: What about the discussion of possible state bankruptcy legislation?
BM: If you look at the current public debate over this issue, consider that 24 states currently allow municipalities to declare bankruptcy, and in the past 25 years, in our rated universe, only 39 defaults have occurred. Each of the credits that defaulted had been rated non-investment grade. So bankruptcy is not a widely used tool by governments that have access to it now. Even if they do ... take Vallejo, California, they did it three years ago and it’s still tied up in the courts, they still haven’t achieved the financial relief that they were hoping for. So it isn’t necessarily a panacea for fiscal stress to begin with.
If you really look at the political debate about state bankruptcy that is occurring, for the most part state officials are saying that they don’t want or need it and they want people to stop talking about it because it’s hurting their debt markets. I don’t think there are any state officials that are willing to declare defeat – I think it’s the opposite, most of the governors are going into these difficult situations with the attitude that they will do what they have to do to make things right. We also aren’t seeing a lot of support for this idea in Washington. Eric Cantor is the House Majority Leader and he has already said that he wouldn’t support a bill that changes the law.
The people who are talking about bankruptcy seem to be primarily politicians who are out of office currently, and it’s hard to understand what their motives are. I haven’t heard any one of them actually say that it’s time for State governments to default on debt obligations to bondholders. If they did, it would mean they do not understand how state governments finance themselves. They have cyclical revenues and they absolutely need to borrow on a short-term basis every year. The actual impact of a state default would be catastrophic to the entire market.
II: If legislation were introduced how would your group react?
BM: If legislation on the federal level did clear the way for state bankruptcy we wouldn’t alter our view on the whole sector, we would watch each individual credit’s reaction to the change. It would weaken the structural credit framework of state governments, but it wouldn’t automatically push us to take any unilateral action.
Andrew Barber is the director of strategic investments for Waverly Advisors, a Corning, NY based asset management firm.
