Despite Deficits, No Crisis Yet Regarding Municipal Debts

Published August 23, 2010

In several major cities and at least one county this year, the specter of bankruptcy and debt default haunts taxpayers and local government officials. And the continuing economic slump is making recovery even more difficult.

Places such as Detroit; Harrisburg, Pennsylvania; Jefferson County, Alabama; Los Angeles; and San Francisco have all teetered on the brink of default. Buena Vista, Virginia, population 6,400, could lose its city hall, which the city put up as collateral for a $9.2 million loan for a municipal golf course. And in May, Central Falls, Rhode Island, population 19,000, went into receivership.

Possible $85 Billion Deficit
The National League of Cities says municipal governments cumulatively face budget deficits from 2010-2012 of between $55 billion and $85 billion.

Historically, municipal bonds—which help fund sewer and water projects, building construction, and other municipal projects—have proven to be sound investments, with a default rate for investment-grade bonds at less than half a percentage point, according to bond rating agency Moody’s Investor Services. That’s about one-third the rate of corporate debt defaults, Moody’s says.

But are municipal bonds becoming riskier?

Not significantly, says Christopher Hoene, director of research for the National League of Cities.

‘Circumstances Beyond Fiscal Stress’
He said there might be a few bankruptcies but added there has been “too much focus on the bankruptcy question. In almost all of the cases where bankruptcy is on the table, there are extenuating circumstances beyond fiscal stress,” he said.

Case in point: Pennsylvania’s state capitol, Harrisburg. The city is an astonishing $288 million in debt because of its decision to build a huge new trash incinerator. Bond interest payments this year are $68 million—approximately $3 million more than the city’s entire annual budget.

The Harrisburg Authority, the governing body that issued the debt to build the incinerator, has already missed several payments, but it won a court victory August 11 when a Dauphin County Court judge dismissed a lawsuit demanding the county be reimbursed for a $775,652 debt payment it made for the Authority last year.

Revenue from the incinerator was supposed to pay back the borrowed money, but revenues have come nowhere near projections.

‘Sounds Worse Than It Is’
Lisa Kreiling, a senior municipal bond analyst for PNC Capital Advisors, LLC in Philadelphia, said she believes news stories about possible municipal defaults “are making the situation sound worse than it really is, because they are focusing on municipalities that are in the worst shape.

“Most water and sewer districts are in good shape. The financial situation is bad, but the reality is most [municipalities] are making midyear adjustments to budgets, cutting spending. We don’t hear about ones that had healthy reserves and are weathering through it. Most are doing what they need to do, even though it might be difficult.”

Hoene said municipal governments are facing two main problems: the economic downturn, which has caused many sources of revenue to drop, including sales, property, and income taxes; and structural problems related to compensation for government workers, including retirement and health insurance benefits.

“The revenue shortfalls plaguing states and local governments are mostly about declining economic activity in comparison to what we were seeing pre-2008,” he said. “However, there are underlying fiscal stresses facing local governments that go beyond the recession. Pension and health care costs are foremost among these stresses.”

‘Won’t Happen Overnight’
Despite the political pull of government worker unions, which fight most attempts to roll back pay and perks, reforms are beginning to happen Hoene says.

“Pension costs can be brought into line by changing the structure of the benefit packages. Health care costs share some of the same stresses, but are mostly a function of costs that are going up for health care in all sectors of the economy. Cities are moving to restructure health care benefit packages, but in many cases it’s to offset costs that are rising beyond levels that their revenues can keep up with from year to year,” according to Hoene.

“In both cases, the turnaround needed won’t happen overnight. Restructuring benefit packages often means that the packages for newer employees are different from employees and/or retirees that are grandfathered in under existing structures, which means the potential cost savings phase in over time.”

Spending Discipline Essential
Kreiling says she believes many municipalities have begun taking steps to deal with these problems. In studying the creditworthiness of municipalities, she sees certain common features of financially strong local governments:

“They maintain low debt burdens, have a debt service plan that is strongly monitored, a good mix of commercial and residential tax bases, and good revenue forecasting. By this I mean they are not aggressive in assuming strong revenue growth.

“They also show discipline in building reserves. When times are flush, the tendency is to spend it. A lot of cities with the strongest financial profile say X percent goes to a rainy day fund in good times or bad,” Kreiling added. “When we have a recession like this one, they can tap into those reserves. Another good feature is willingness to adjust the budget by making spending cuts instead of papering over problems with additional debt.”

Steve Stanek ([email protected]) is a research fellow at The Heartland Institute and managing editor of Budget & Tax News.